Wednesday, December 19, 2012

Making sense of the budget surplus saga

I hate to burden you with a topic as earnest as the budget deficit so close to the holidays - I had hoped to write about the idea of giving someone a goat for Christmas - but the saga of whether the Gillard government will manage to get its budget into surplus this financial year has reached farcical proportions.

A few weeks ago we learnt from the national accounts that the economy's rate of growth slowed to 0.5 per cent in the three months to September. When some parts of the media concluded the most significant implication of this news was that it increased the likelihood of the budget balance not returning to surplus (which it does) I realised the public debate was running off the rails.

Contrary to the impression we are being given, the budget balance is a means to an end, not an end in itself. We don't run the economy to balance the federal government's budget. And when we get our quarterly report on how the economy's travelling, the primary question is not what it tells us about the government's performance or it political prospects.

The budget was made to serve the economy, not the other way round. And the economy was made to serve us. So the primary question to be asked when we receive the quarterly report card is what it implies for us. Is our material standard of living improving more slowly than we'd prefer? Is inflation getting worse? Is the economy growing fast enough to stop unemployment rising?

These things matter because they matter to us and our lives. It's only because they matter to us that they also matter to the fortunes of the governments we re-elect or toss out. So the economic implications of the budget balance come first, the political implications are very much secondary.

Trouble is, for both the public and the media, the political implications of the budget balance are deceptively simple, whereas the economic implications are complicated and, to many, incomprehensible.

Politically, the only thing people think they need to know is that anything called a deficit must be bad and anything called a surplus must be good. Most political reporting about the budget balance is based on this assumption.

The opposition has been reinforcing this simplistic reasoning unceasingly from the moment in 2009 it became clear the global financial crisis had pushed the budget balance into deficit. Its success explains why, in the election campaign of 2010, a foolhardy Julia Gillard took a mere Treasury projection that the budget would be back in surplus by 2012-13 and elevated it to the status of a solemn promise.

Economically, however, it ain't that simple. From an economic perspective, budget deficits are bad in some circumstances, but good in others. Similarly, budget surpluses are good in some circumstances but bad in others.

How could this be so? It's because national government budgets operate at two quite different levels. At one level the government's budget is the same as that for a business or a household: it's a forecast of how much money will be coming in and going out during a year. You use budgets to ensure things go to plan and you don't get in deeper than you can handle.

At another level, however, the budgets of national governments are quite different from other budgets. Because they're so big relative to the size of the economy - equivalent to about a quarter - what's happening to the economy has a big effect on the budget. But the budget is so big it can also be used to affect what happens to the economy.

This is something few non-economists seem to understand. People who focus solely on the political implications of the budget, assume that if the budget moves from surplus to deficit this could only be because the government has chosen to spend more than it is raising in taxes. If the budget moves from deficit to surplus, this could only be because the government has chosen to spend less than it's raising in taxes.

Not so. The other reason budgets go from surplus to deficit is that when the economy turns down, this causes tax collections to slow or even fall and government spending (particularly on unemployment benefits) to grow rapidly. Similarly, the other reason budgets go from deficit to surplus is that the economy speeds up, causing tax collections to grow rapidly and spending on unemployment benefits to fall as more people find jobs.

This automatic deterioration in the budget balance is what happened after the financial crisis hit business and consumer confident so hard. In this case, the descent into deficit was good, not bad. Why? Because it represented the budget helping to break the economy's fall during the downturn.

What complicates matters was Kevin Rudd's decision to use a temporary burst of government spending to stimulate the economy out of its downturn. At this point we had the economy making the budget balance worse automatically, but also the government choosing to add to the worsening as a way of hastening the economy's eventual recovery.

But just as the budget balance deteriorates automatically when the economy turns down, so it improves automatically when the economy recovers and resumes its growth. Treasury's projection the budget would be back in surplus by 2012-13 was based mainly on its assumption of a strong recovery in tax collections.

This hasn't been happening, thus making the return to surplus unlikely. From an economic perspective, it's the weak recovery that's worth worrying about, not the delayed return to surplus. From an uncomprehending political perspective, however, that won't save Gillard from a caning.

Monday, December 17, 2012

Executives put their salaries ahead of shareholders

For almost as long as big business has been crusading for a lower rate of company tax, I've been puzzling over its motives. Why are these people fighting for something of little or no benefit to their domestic shareholders and likely to be quite unpopular?

The willingness with which our economic establishment has gone along with the calls for lower company taxes is one of the great mysteries of the year. . Now the Organisation for Economic Co-operation and Development has signed up as an urger in its latest report on Australia.

But as David Richardson demonstrated on Saturday in his technical brief for the Australia Institute, claims that a lower rate of company tax would lead to more investment, faster economic growth and higher employment are surprisingly weak when you bother to examine them.

The puzzle doesn't end there, however. If lower company tax was of benefit to shareholders, it wouldn't be surprising to see big business arguing for it, even if it was of little or no benefit to the wider economy. But even this motivation doesn't hold.

The push for lower company tax is enthusiastically pursued in the United States, and this wouldn't be the first reform push we'd imported holus-bolus from there. Just one small problem: we have a full dividend imputation system that the Yanks don't have.

It wouldn't be all that surprising if many economists - and many punters - weren't quite on top of how dividend imputation affects the push for a lower company tax rate. It would be amazing, however, if our chief executives didn't understand it. You'd also expect a lot of investment professionals - fund managers, their myriad consultants, stockbrokers - to know the score.

The point is simply stated: when the rate of company tax is 30 per cent, the recipients of fully franked dividends are entitled to a refundable tax credit worth 30 per cent of the grossed-up value of the dividend.

So if your marginal tax rate is 46.5 per cent, the extra income tax you have to pay on your grossed-up dividend falls to a net 16.5 per cent. In this way the double taxation of dividends is eliminated.

Now let's say the big business lobby succeeds in persuading the government to cut the company tax rate to 25 per cent. With an unchanged dividend, the refundable tax credit falls to 25 per cent and the remaining tax to be paid rises to 21.5 per cent.

Only if companies were to respond to the lower company tax rate by increasing their dividend payouts sufficiently, would domestic shareholders not see themselves as having been made worse off.

The introduction of dividend imputation led to a reduction in listed companies' efforts to minimise their company tax because Australian investors much prefer to hold the shares of companies paying enough tax to allow them to fully frank their dividends. Companies unable to deliver fully franked dividends can expect their share price to be marked down accordingly.

This is particularly true of Australian super funds, which are able to use imputation credits to largely extinguish the 15 per cent tax they pay on their annual investment earnings. (This tax quirk probably explains why our super funds are overinvested in shares and underinvested in fixed-interest areas.)

When you remember the way our chief executives bang on endlessly about shareholder value being their sole and sacred objective, you can only wonder why they pursue a cut in the company tax rate so fervently.

They're always distributing league tables showing our 30 per cent company tax rate as the equal seventh-highest among the 34 countries in the OECD. They never point to tables showing the combined effect of the company tax rate and the top personal tax rate. If they looked at it from this domestic shareholders' perspective, we'd fall to being just the 15th highest, with the US and Britain well above us.

For a long time I wondered whether the Business Council - many of whose members are largely foreign-owned - was championing the interests of foreign shareholders rather than locals.

It's true many foreign shareholders in Australian companies would benefit from a lower company tax rate because they're not eligible for imputation credits. One of the main reasons for the continued existence of company tax is to ensure the foreign owners of Australian businesses pay their fair share of Australian tax.

But not even all foreign shareholders would benefit from lower company tax. Americans (who account for more than a quarter of the stock of foreign investment in Australia) would gain nothing because the company tax rate they pay when they bring dividends home is already higher than our 30 per cent (for which they get a deduction). They wouldn't gain, but our Treasury would lose.

So what is big business on about? In his paper for the Australia Institute, Richardson argues it's a case of company executives pursuing their own interests, not those of the shareholders they profess to serve. (Economists call this a principal-and-agent problem.)

A lower rate of company tax would make companies' after-tax profits bigger, thus making their chief executives look more successful and probably leading to an increase in their remuneration.

It would also allow companies to retain and reinvest more after-tax earnings. This would make their companies bigger - which would probably also justify bosses being paid higher remuneration.

We already know chief executives play such self-seeking games because of all the mergers and takeovers, which rarely leave shareholders better off, but invariably leave the instigating chief executive more highly paid.

Saturday, December 15, 2012

The case against a lower company tax rate

One of big business's greatest disappointments this year was its failure to persuade the Gillard government to cut the 30 per cent rate of company tax. On business's economic reform wish-list, cutting company tax is second only to getting more anti-union provisions back into industrial relations law.

So you can be sure business will be campaigning for lower company tax in the months leading up to next year's federal election.

I'm sure many business people regard the benefits of lower company taxation as so obvious as to be self-evident but, in economics, you have to spell out just why you believe a lower tax rate would make the economy a better place.

Presumably, the argument is that lower company tax would encourage greater investment in business activity, thus making the economy grow faster and create jobs.

It's surprising there's been so little debate of this proposition among supposedly argumentative economists - until now. On Saturday, the Australia Institute will publish on its website a technical brief by David Richardson, "The Case Against Cutting the Corporate Tax Rate".

According to Richardson, company tax has the great virtue of being a tax on profit. If you don't make a profit, you don't pay the tax. So company tax doesn't add to the cost of doing business, meaning the imposition of the tax makes no difference to the profitability of business activities. And, since the tax is applied at the same rate to profits from all business activities, it should have no effect on decisions about which activities to pursue, or how much activity to undertake.

"By contrast, many other taxes are payable whether or not the company makes a profit," Richardson says. "For example, the iron ore royalty rate in Western Australia will soon be 7.5 per cent of the value of the iron ore mined. If the mining company receives $100 a tonne, pays $7.50 in royalties and has expenses of $95 a tonne, it will run at a loss ... There is no way a profit-related tax can do that."

In exposing this logical flaw in the argument that the rate of company tax affects the amount of business activity undertaken, Richardson quotes the Nobel laureate Joseph Stiglitz from a book he published this year, The Price of Inequality: "If it were profitable to hire a worker or buy a new machine before the tax, it would still be profitable to do so after the tax ... what is so striking about claims to the contrary is that they fly in the face of elementary economics: no investment, no job that was profitable before the tax increase, will be unprofitable afterward."

Richardson reminds us that, according to elementary economics, investment will continue until the return on the marginal investment is just equal to the cost of capital. This is true whether you evaluate the investment on a pre-tax or post-tax basis. Why? Because, although company tax will reduce the return on the investment, it will also reduce the (after-tax) cost of capital. If returns are taxed, interest costs become tax deductible.

Richardson notes that the economists Gravelle and Hungerford, of the US Congressional Research Service, who reviewed the empirical evidence that might or might not support claims that lower company tax increases economic growth, debunk the notion.

It's widely argued that because Australia is a "capital-importing country" and needs a continuous inflow of foreign equity investment, we need to keep our company tax rate competitive if we're to attract all the funds we need. Since other countries have been lowering their rates, we must lower ours.

But Richardson says Gravelle and Hungerford showed "there was no convincing empirical evidence that suggested international capital flows were influenced by corporate tax rates. The differences among Organisation for Economic Co-operation and Development [member countries'] rates tend to be so small as to hardly matter compared with other factors".

He says a good deal of foreign investment in Australia comes from Asian countries with much lower company tax rates than ours. In 2011, China was the third-highest foreign investor in Australia by value during the year, while India was fifth, Singapore was sixth, Thailand 12th and Malaysia 14th.

"The simple point is that Australia attracts investments originating in the very economies that are supposed to have more competitive taxation systems," he says.

Note that the US accounts for 27 per cent of the accumulated stock of foreign investment in Australia, Britain for 23 per cent and Japan for 6 per cent.

An argument against cutting our company tax rate is that, because of the way double-taxation agreements between countries work, where foreign investors in Australia come from countries whose company tax rate is higher than ours - such as the US - they gain no advantage from our lower rate. What they save in payments to our taxman just increases their payments to their own taxman.

When, at a tax summit last year, the ACTU expressed opposition to a cut in company tax, business and its economist supporters retorted that, when you work it through, the burden of company tax ends up being borne mainly by wage earners.

That is, businesses pass the burden of company tax on to their customers in the form of higher prices, and most customers are wage earners. Didn't the unionists know this? Why were they so ill-informed?

It's true that, being inanimate objects, companies don't end up paying tax: only people pay tax. So the burden of company tax must be shifted to customers, employees or shareholders, or some combination. But determining just who, in practice, ends up shouldering the burden of a tax is notoriously hard.

It's true, too, there's been a rash of studies purporting to show it's the workers who end up carrying the can. But the Congressional Research Service report criticised those studies and showed their results were unrealistic.

One study, for instance, estimated a 10 percentage-point increase in the corporate tax rate would reduce annual gross wages by 7 per cent. But when Richardson applied that rule to our economy, he found it was saying such a move would increase company tax collections by $22.5 billion and reduce wages by $49.6 billion.

Pretty hard to believe. Incredible, in fact. The economic case for a lower company tax rate is surprisingly weak.

Wednesday, December 12, 2012

Poverty rises as you move from the centre

In Bill Bryson's fascinating book, Shakespeare, he says we know remarkably little about the man, and most of what we think we know has been dreamt up by overenthusiastic scholars. But of at least one point he was sure: in Shakespeare's London, rich and poor lived side by side. A case, I guess, of the rich man in his castle, the poor man at his gate.

They don't make cities like that anymore. Or rather, modern cities seem to be a lot more socially segregated, with the rich tending to live together on one side of the tracks and the poor living on the other.

Research undertaken some years ago by economists at the Australian National University found Australian cities had become more divided, and there is much American research to similar effect. But a research report to be issued on Wednesday has found something a bit different. It is Promoting Inclusion and Combating Deprivation, by Professor Peter Saunders and Dr Melissa Wong, of the Social Policy Research Centre at the University of NSW.

They conducted a survey of 6000 people drawn at random from around Australia in May 2010. They got more than 2600 responses, which they divided into six categories according to where people lived: inner metropolitan area, outer metropolitan, large towns (more than 25,000 people), larger country towns (more than 10,000 people), small country towns (fewer than 10,000 people) and rural areas.

Not surprisingly, they found there were poor, socially disadvantaged people living in all areas. But they also found a strong correlation between where people live and how likely they are to be socially disadvantaged. As the degree of population concentration declines, the rate of social disadvantage tends to increase. To be blunt, the further out you go from the centre of big cities, the higher the proportion of poor people you find.

After allowing for family size, the average disposable income of households was $970 a week. But inner metropolitan households averaged 12 per cent above this, whereas rural households averaged 14 per cent below. (Of course, if some locations have a higher proportion of retired people, the average income will be lower.)

In inner metropolitan areas, the proportion of households living in poverty (that is, with incomes below half the median income) was 12 per cent. It rose to 12.4 per cent in outer metropolitan, 12.6 per cent in large towns, 14.8 per cent in larger country towns and 16.8 per cent in small country towns, dropping a little to 15.5 per cent (still the second highest rate) in rural areas.

Those poverty rates were calculated by the researchers. When the survey respondents were asked whether they considered themselves to be living in poverty, their answers followed pretty much the same pattern.

What's notable, however, is that their subjective assessments were about 2 percentage points lower than the calculated rates. So, unlike many of the rest of us, the genuinely poor don't seem to be feeling particularly sorry for themselves.

But poverty – how much money you have to spend – is not the only dimension of social disadvantage. And there's been controversy over the unavoidable arbitrariness of where poverty lines are drawn. So Saunders and his colleagues have put much work into developing a different approach, one based on people's access to 24 items that a majority of Australians responding to an earlier survey regard as the "essentials of life".

The items include a substantial meal at least once a day, warm clothes and bedding, a washing machine, a decent and secure home, roof and gutters that don't leak, a separate bed for each child, presents for family or friends at least once a year, being able to buy medicines prescribed by a doctor, and up to $500 in savings for an emergency.

When you assess the respondents to the latest survey according to their access to these essentials you find the same story: deprivation tends to rise as you progress from inner metropolitan to rural. The highest levels of deprivation are in social functioning (such as regular social contact with other people) and risk protection (such as car insurance).

All very interesting, but also worrying. Higher rates of social disengagement in smaller communities cast doubt on the happy notion that, in the country, everyone knows each other and everyone looks after each other. But it's not surprising that, the further out you are, the less your access to public services such as dentists and childcare. Nor that unemployment rates are usually much higher.

It's possible the socially disadvantaged tend to gravitate to the country – say, because rents are lower. The greater probability, however, is that people living further from the centre are more likely to suffer disadvantage because of the deficiencies of the areas in which they live.

The trouble is, disadvantage breeds disadvantage. Whatever problems you have of your own, they're likely to be compounded if a lot of the people around you have similar problems.

"Once population decline and poverty become entrenched in an area, further problems emerge that act as barriers for those who remain," the researchers say. "The result is that, increasingly, where one lives (or is born) has a major impact on one's life chances."

It follows that, as governments seek to reduce social disadvantage, they should see the disadvantaged not just as individuals needing help, but also as people living in disadvantaged areas – people unlikely to get far unless something is done to improve conditions in their district.


Monday, December 10, 2012

The hidden truth about interest rates

The prize for journalistic innovation of 2012 must surely go to whoever thought of a way to turn a cut in the official interest rate from good news to (the much more valuable) bad news: abandon the media's eternal assumption that everyone's a borrower and let the grey-power lobby bang on about the evils of lower deposit rates.

It's such an improvement on the standard good-into-bad transformation: bleating about the greedy banks not passing on all the rate cut to people with mortgages.

If we keep down this track we can turn all rate stories into bad news: as Reserve Bank board meetings approach you hold the mike up to all the professional urgers predicting death to the economy if rates aren't cut. Then, when the Reserve obliges, you pass the mike to whingeing oldies.

I suppose it's a good thing for the media to discover at long last that interest rates are a two-way street; that though borrowers gain from lower rates, savers lose. And that there are actually a lot more savers than borrowers.

There's just one problem with the newly fashionable bleeding for retired depositors: it doesn't necessarily follow that a cut in the banks' interest rates for people with home loans leads to similar cuts in rates paid to depositors - a point the grey-power lobby didn't bother making clear to a newly sympathetic media.

There are probably few more underreported topics than what's happening to deposit rates. The banks don't mention them in their press releases announcing cuts for borrowers, and the media rarely press the banks to be more forthcoming.

But even if some of the big four banks shave their deposit rates, I doubt they all will. And those that do are not likely to cut them by as much as the 20 basis points they're lopping off mortgage rates.

Why not? Well, if the media had been reporting the whole affair conscientiously, rather than turning it into a comic-book contest between good guys and bad guys, ripoff merchants and impoverished victims, you'd already know why.

The reason the banks haven't been cutting deposit rates the way they've been cutting mortgage rates goes to the heart of their reason for not passing on official rate cuts in full. Since the onset of the global financial crisis in 2008, the banks have been locked in a battle to attract deposits from ordinary Australian savers.

This battle has forced up the rates being paid to depositors. Whereas before the crisis the rates on at-call savings accounts were about 100 basis points below the official interest rate, today they're on par with it. And whereas term-deposit "specials" were below the equivalent rates paid in the wholesale market (bank bills), today they're about 150 basis points above them.

So, savers ought to be the last people complaining about the way events have transpired since the financial crisis changed the rules of the game. They're laughing all the way to the bank.

Indeed, the higher rates being paid to depositors (relative to where the official rate happens to be), are by far the greatest reason the banks have been imposing "unofficial" rate rises on home (and business) borrowers and now are passing on only about 80 per cent of the official rate cuts. The lesser reason is the higher rates they have to pay on their foreign "wholesale" borrowings.

In other words, it's not the banks that are supposedly ripping off poor home buyers, it's the whingeing retirees. The banks' cost of borrowing has increased, and all they've done is pass the higher cost on by cutting mortgage rates by less than the fall in the official rate.

But that doesn't give people with mortgages a licence to feel hard done by. Why not? Because, as the Reserve's deputy governor, Dr Philip Lowe, reminded us yet again last week, the Reserve has cut the official rate by more than it would have, just to ensure home buyers get the desired degree of rate relief. They haven't been short-changed.

On the face of it, the banks have done nothing wrong. They've merely passed on their higher cost of borrowing, leaving their "net interest margin" (the gap between the average rate they charge and the average rate they pay for funds) at about 230 basis points, virtually unchanged from what it was immediately before the crisis.

But it's not that simple. The question we need to ask is the one the media rarely do: why has the banks' cost of borrowing risen so much since the crisis? And why has a deposit-seeking war broken out among them?

Short answer: because the crisis revealed them to be dangerously dependent on foreign wholesale borrowing for their funds. So, the sharemarket and the credit rating agencies have forced them to lift their reliance on "stickier" retail deposits to about 54 per cent of their total funding.

But this means running a bank is now less risky than it was before the crisis. This, in turn, means their risk-adjusted rate of return on capital no longer needs to be as high as it was.

So, the degree of competition among the banks is sufficient to force them to give depositors a much better deal, and sufficient to have them wanting to preserve their profitability (and their chief executives' remuneration packages) relative to the others, but insufficient to force down their rates of return the way the textbook says should happen.

In all the millions of angry words the media have spilt on the topic this year, the hidden truth is that home borrowers have little to complain about and depositors even less - save for the small truth that our banks remain far more profitable than they need to be.

Saturday, December 8, 2012

Economy slowing, not dying

To hear many people talk, the economy is in really terrible shape. Trouble is, we've been waiting ages for this to show up in the official figures, but it hasn't. This week's national accounts for the September quarter are no exception.

You could be forgiven for not realising this, however, because some parts of the media weren't able resist the temptation to represent the figures as much gloomier than they were.

One prominent economist was quoted (misquoted, I trust) as inventing his own bizarre definition of recession so as to conclude the economy was in recession for the first nine months of this year.

Really? Even though figures we got the next day showed employment grew by 1.1 per cent over the year to November, leaving the unemployment rate unchanged at 5.2 per cent? Some recession.

What the national accounts did show - particularly when you put them together with other indicators - is that the economy is in the process of slowing, from about its medium-term trend growth rate of 3.25 per cent a year to something a bit below trend.

That's not particularly good news - it suggests unemployment is likely to rise somewhat - but it hardly counts as an economy in really terrible shape.

The accounts show real gross domestic product growing by 0.5 per cent in the September quarter and by 3.1 per cent over the year to September - which latter is "about trend".

This quarterly growth of 0.5 per cent follows growth of 0.6 per cent in the previous quarter and 1.3 per cent the quarter before that. So that looks like the economy's slowing - although the figures bounce around so much from quarter to quarter it's not wise to take them too literally.

But the accounts contain a warning things may slow further. We always focus on the growth in real gross domestic product, which is the quantity of goods and services produced during the period (and is the biggest influence over employment and unemployment).

But if you adjust GDP to take account of the change in Australia's terms of trade with the rest of the world, to give a better measure of our real income, you find "real gross domestic income" fell by 0.4 per cent in the quarter to show virtually no growth over the year.

Leaving other factors aside, this suggests our spending won't be growing as fast next year, leading to slower growth in the production of goods and services (real GDP) and thus slowly rising unemployment.

Our terms of trade are falling back from their record favourable level because of the fall in coal and iron ore export prices as the first stage of the three-stage resources boom ends. (The second stage is the mining investment boom and the third is the rapid growth in the quantity of our mineral exports.)

For some time the econocrats and other worthies have been reminding us that, when ever-rising export prices are no longer boosting our incomes, we'll be back to relying on improved productivity - output per unit in input - to lift our real incomes each year.

This makes it surprising we've heard so little about the figures showing that GDP per hour worked rose by 0.7 per cent in the quarter and by a remarkable 3.3 per cent over the year. Again, it's dangerous to take short-term productivity figures too literally, but at least they're pointing in the right direction.

They also put a big question mark over all the agonising we've heard about our terrible productivity performance.

This week's figures confirm what we know: some parts of the economy are doing much worse than others. Business investment in plant and construction rose by 2.6 per cent in the quarter and 11.4 per cent over the year - though most of this came from mining, with investment by the rest of business pretty weak.

One area that isn't as weak as advertised is consumer spending, up by 0.3 per cent in the quarter and 3.3 per cent over the year - about its trend rate. The household saving rate seems to have reached a plateau at about 10 per cent of disposable income, meaning spending is growing in line with income.

Investment in home building grew 3.7 per cent in the quarter, suggesting its chronic weakness may be ending, thanks to the big fall in interest rates. Adding in home alterations, total dwelling investment was up 0.7 per cent in the quarter, though still down 6.3 per cent over the year.

The volume (quantity) of exports rose 0.8 per cent in the quarter and 4.7 per cent over the year, whereas the volume of imports rose 0.1 per cent and 3.5 per cent, meaning "net exports" (exports minus imports) are at last making a positive contribution to growth. This suggests we're starting to gain from the third stage of the resources boom, growth in the volume of mineral exports. The greatest area of weakness was spending by governments. Government consumption spending was down 0.4 per cent in the quarter (but still up 3.5 per cent over the year). Government investment spending fell 8.2 per cent in the quarter and 7 per cent over the year even though, within this, investment spending by government-owned businesses was strong.

All told, the public sector made a negative contribution to GDP growth of 0.5 percentage points in the quarter, and a positive contribution of just 0.3 per cent over the year - obviously the consequence of budgetary tightening at both federal and state levels.

This degree of contraction isn't likely to continue. But a strong reason for accepting the economy is slowing somewhat is the news from the labour market.

Don't be fooled by the monthly farce in which unemployment is said to jump one month and fall the next. If you're sensible and use the smoothed "trend estimates" you see unemployment steady at 5.3 per cent since August.

Even so, the economy hasn't been growing fast enough to employ all the extra people wanting work, causing the working-age population's rate of participation in the labour force to fall by 0.4 percentage points to 65.1 per cent.

And we know from the labour market's forward-looking or "leading" indicators - surveys of job vacancies - that employment growth is likely to be weaker in coming months.

That's hardly good, but it ain't the disaster some people are painting.

Wellbeing index gives better picture of mining boom

DON'T believe the doomsayers.This week's national accounts indicate the economy is slowing to something a bit below trend but the critics of the great god gross domestic product are right: it is a quite inadequate and often misleading measure of the nation's progress.

This is why, for more than a year, the Herald has commissioned Dr Nicholas Gruen, principal of Lateral Economics, to calculate a broader index of wellbeing, which we have published within a few days of the release of the Bureau of Statistics' quarterly national accounts, with GDP as their centrepiece.

Our purpose has been to supplement rather than supplant the official figures, which have valid - if narrower - uses and were never intended to be treated as the nation's all-encompassing bottom line.

The Herald-Lateral Economics wellbeing index uses the national accounts to produce a modified version of GDP called "net national disposable income". This adjustment takes account of the annual depreciation (using up) of man-made capital and of the income earned within Australia which isn't owned by Australians.

It also shifts the focus from the value of the nation's production to how much disposable income the nation's households have available to spend on consumption or save, in the process allowing for the change in the prices of our exports relative to the prices of imports.

To this figure the index adds adjustments for the value of the net depletion of natural resources (after allowing for new discoveries), the estimated cost of future climate change, all levels of education and training, changes in income inequality, various measures of the nation's health and employment-related satisfaction.

All this means the index is well placed to help answer a question on many people's minds: what will we have to show for the resources boom?

Unlike GDP, the wellbeing index takes account of the loss of the minerals dug up and sent overseas, not just the export income earned from doing so. It also takes account of the loss of real income we have suffered from the end of the first stage of the boom: the marked decline in the world prices of coal and iron ore during the three months to the end of September.

This was the main factor that converted the growth of 0.5 per cent in GDP during the quarter - a measure of the quantity of goods and services produced in the economy - to a fall of 0.7 per cent in our net national disposable income.

But the accounts confirm that Australian households are continuing to save the high proportion of their disposable incomes. So that is proof we have been saving rather than spending some of our windfall gain from the boom.

But the broader index shows we have also increased our investment in the education and training of our workforce. So much so that, despite the fall in export prices, the index rose by 0.2 per cent during the quarter.

We should be using our good fortune to raise the value of workers' labour and improve their lives in the years ahead - and the wellbeing index shows we are.

Wednesday, December 5, 2012

Top economist says what we hardly dare to think

Just as it s taking the world a lot longer to recover from the global financial crisis than we initially expected, so it s taking a lot longer than we might have expected for voters and their governments to learn the lessons and make the changes needed to ensure such devastation doesn t recur. But the penny has dropped for some.

Jeffrey Sachs, of Columbia University, is one of the biggest-name economists in the world. Yet in his book, The Price of Civilisation: Economics and Ethics after the Fall, he admits America s greatest problem is moral, not economic. Actually, he says that at the root of America s economic crisis lies a moral crisis. He puts into words thoughts most of us have hardly dared to think.

Sachs says America s weaknesses are warning signs for the rest of the world. The society that led the world in financial liberalisation, round-the-clock media saturation, television-based election campaigns and mass consumerism is now revealing the downside of a society that has let market institutions run wild over politics and public values, he says.

His book tracks the many ills that now weigh on the American psyche and the American financial system: an economy of hype, debt and waste that has achieved economic growth and high incomes at the cost of extreme income inequality, declining trust among members of the society and the public s devastating loss of confidence in the national government as an instrument of public well-being .

Even if the American economy is on the skids, he says, the hyper-commercialism invented in America is on the international rise. So, too, are the attendant ills: inequality, corruption, corporate power, environmental threats and psychological destabilisation.

A society of markets, laws and elections is not enough if the rich and powerful fail to behave with respect, honesty and compassion toward the rest of society and towards the world. America has developed the world s most competitive market society but has squandered its civic virtue along the way.

Without restoring an ethos of social responsibility, there can be no meaningful and sustained economic recovery.

America s crisis developed gradually over several decades, he argues. It s the culmination of an era the baby-boomer era rather than of particular policies or presidents. It is a bipartisan affair: both Democrats and Republicans have played their part.

On many days it seems that the only difference between the Republicans and Democrats is that Big Oil owns the Republicans while Wall Street owns the Democrats.

Too many of America s elites the super rich, the chief executives and many academics have abandoned a commitment to social responsibility. They chase wealth and power, the rest of society be damned, he says.

We need to reconceive the idea of a good society. Most important, we need to be ready to pay the price of civilisation through multiple acts of good citizenship: bearing our fair share of taxes, educating ourselves deeply about society s needs, acting as vigilant stewards for future generations and remembering that compassion is the glue that holds society together.

The American people are generally broadminded, moderate and generous, he says. But these are not the images of Americans we see on television or the adjectives that come to mind when we think of America s rich and powerful elite.

America s political institutions have broken down, so that the broad public no longer holds these elites to account. And the breakdown of politics also implicates the public. American society is too deeply distracted by our media-drenched consumerism to maintain habits of effective citizenship.

Sachs says a healthy economy is a mixed economy, in which government and the marketplace play their roles. Yet the federal government has neglected its role for three decades, turning the levers of power over to the corporate lobbies.

The resulting corporatocracy involves a feedback loop. Corporate wealth translates into political power through campaign financing, corporate lobbying and the revolving door of jobs between government and industry; and political power translates into further wealth through tax cuts, deregulation and sweetheart contracts between government and industry. Wealth begets power, and power begets wealth.

How have American voters allowed their democracy to be hijacked? Most voters are poorly informed and many are easily swayed by the intense corporate propaganda thrown their way in the few months leading to the elections.

We have therefore been stuck in a low-level political trap: cynicism breeds public disengagement from politics; the public disengagement from politics opens the floodgates of corporate abuse; and corporate abuse deepens the cynicism.

Sachs says globalisation and the rise of Asia risks the depletion of vital commodities such as fresh water and fossil fuels, and long-term damage to the earth s ecosystems.

For a long time, economists ignored the problems of finite natural resources and fragile ecosystems, he writes. This is no longer possible. The world economy is pressing hard against various environmental limits, and there is still much more economic growth and therefore environmental destruction and depletion in the development pipeline.

Two main obstacles to getting the global economy on an ecologically sustainable trajectory exist, he says. The first is that our ability to deploy more sustainable technologies, such as solar power, needs large-scale research and development.

The second is the need to overcome the power of corporate lobbies in opposing regulations and incentives that will steer markets towards sustainable solutions. So far, the corporate lobbies of the polluting industries have blocked such measures.

In Australia, of course, the public interest has so far triumphed over corporate resistance. But the survival of both the carbon tax and the mining tax remains under threat.

Monday, December 3, 2012

Treasury secretary cracks the whip over super funds

When Peter Costello announced his mindbogglingly generous changes to the taxation of superannuation in 2006, the air was thick with economists prophesying such profligacy would soon prove unsustainable.

Even in business circles, the good news was widely judged too good to last. Super payouts would be tax-free for those 60 and over (thus making people's age as well as the extent of their income a criterion for how much tax they paid) and the salary-sacrifice lurk for the better off was opened wide.

At the time, Treasury, whose advice seemed to have been followed by the Howard government, wasn't having a bar of the conventional criticism, and I volunteered to make sure the government's side of the story got an airing.

Since the arrival of the Rudd-Gillard government, however, the approach to super seems to have changed, suggesting the policy advice may also have changed. Despite (or maybe because it is) planning to phase up the compulsory employer contribution rate from 9 per cent of salary to 12 per cent, Labor has been chipping away at the cost - and the unfairness - of the super tax concession. It has largely eliminated the salary-sacrifice lurk, corrected the situation where those on low incomes gained no concession on their contributions and, in effect, restored the Howard government's 15 per cent super surcharge for those earning more than $300,000 a year.

Last week, the present secretary to the Treasury, Dr Martin Parkinson, removed any doubt that Treasury's attitudes have changed in a tough speech to the super funds association. He warned that, looking ahead, there were challenges for the present super arrangements. An obvious one, he said, was the ageing of the population. Although Australia was much better placed than many of the developed economies to cope with the budgetary costs of ageing, "the question remains, however, whether the current framework for our superannuation system will be sustainable into the future. While changes to the superannuation guarantee have been important for improving adequacy, they will clearly come at the cost of forgone revenue. Also, governments over time have introduced a range of concessions that encourage increased voluntary saving in superannuation. Again, these concessions come at a cost, indeed a very significant cost.

"With the Commonwealth budget coming under increasing pressure over the next few decades, the fiscal sustainability of all policies, including superannuation, will demand greater public scrutiny. This scrutiny will be even more important to the extent that existing concessions are seen to favour some at the expense of the majority."

When you remember all the promises both sides are taking into next year's election, and the difficulty whoever wins will have keeping the budget on track, it is not hard to guess where Treasury will be suggesting they look for savings.

Apart from the motor industry, there are not many sectors greedier in their rent-seeking than the super sector. Dr Parkinson took the opportunity to remind the funds in person he is no soft touch. How is this for frankness: "The government ensures the superannuation sector is provided with a steady, guaranteed and concessionally taxed supply of money. No other industry has this guarantee. None."

That sounds to me like a heavy hint the government is entitled to, first, keep the industry pretty tightly supervised and, second, expect a high standard of performance. He who pays the piper ...

"I would suggest that the superannuation industry has a responsibility to its stakeholders, including members and the government, to invest money prudently so the returns are in the best interests of members and to develop new products to meet the demands of our ageing population," he said.

"To date, the superannuation sector has focused primarily on the accumulation phase. But as the system matures, as more people move into the withdrawal phase, and as people in general live longer, there will be increased demand on the industry to assist individuals to manage the various phases of retirement and key risks like longevity ...

"Members reasonably ask: What has super delivered for me? And, more importantly, what will super deliver for me into the future? That means asking tough questions about the industry's readiness and capability to meet future challenges."

Now cop this: "I am not necessarily advocating any particular investment pattern, although I do have reservations about excessive reliance on equities."

It is a safe bet that, not long after the contribution rate reaches 12 per cent of salary, the industry will resume agitating for it to be raised to 15 per cent.

Dr Parkinson left the super funds in no doubt where he stands on the question of super's adequacy, quoting the example of a 30-year-old entering the workforce today, earning median wages and working for 37 years. They are projected to retire with an income equivalent to 90 per cent of their standard of living while working.

He said the level of super funds' management fees had been "a concern for Treasury". To tackle this concern, the government commissioned the Cooper review, from which had emerged its "stronger super" reforms, including SuperStream and MySuper.

SuperStream will see greater automation, common date standards and a network to centralise information and transactions. MySuper will provide a low-cost default super product that removes unnecessary and costly features.

The reforms could increase the retirement payout of a typical young worker by $40,000. I get the feeling that, should industry resistance prevent the reforms from delivering as expected, the issue will stay on Treasury's to-do list.

Saturday, December 1, 2012

The two speeds not as far apart as claimed

Some people spent much of this year worrying about how the two-speed economy was affecting the south-eastern states. There was concern Victoria was on the brink of recession and South Australia and Tasmania were already in one.

So when, a week or two back, the Bureau of Statistics finally published the figures for the real growth in the various states' gross state product last financial year, 2011-12, there would have been great interest from the media, right?

Wrong. The only definitive figures we've had for economic growth by state for the past 12 months went virtually unreported.

Why? Because they were a bit dated? No. More likely because they showed no sign of recession. They also showed the gap between the fast and slow states to be narrower than we'd been led to believe.

Turns out we did a lot of worrying for nothing, misled by figures we should have known are always misleading.

The unreported figures show Victoria's gross state product grew by 2.3 per cent for 2011-12 as a whole, just a fraction less than NSW's 2.4 per cent. South Australia grew by 2.1 per cent and even Tasmania pushed ahead by 0.5 per cent.

By contrast, Queensland grew by 4 per cent and Western Australia by 6.7 per cent. Overall, gross domestic product (the national measure) grew by a respectable 3.4 per cent.

A point to remember, however, is that the populations of the states are growing at quite different rates and this accounts for part of the difference in the rates at which their economies are growing. Only to the extent a state's gross state product per person is increasing is it better off materially.

Nationally, economic growth of 3.4 per cent in 2011-12 drops to 1.8 per cent per person. Queensland's growth drops from 4 per cent to 2.2 per cent, while WA's drops from 6.7 per cent to 3.7 per cent.

Not quite so much cause for envy.

If you recollect reading during the year figures a lot more dramatic than these, you're right, you did. As I say, definitive figures for gross state product are published only once a year, on an annual basis. The figures the bureau publishes each quarter as part of the national accounts are for something quite different: state final demand.

These figures are always widely reported by the media, with journalists happily assuming SFD and GSP must surely be pretty much the same thing. Trouble is, they're not. And the media's insistence on reporting these largely meaningless figures means the public is regularly misled about the extent of differences between the state economies.

State final demand and gross state product would be pretty much the same thing if the states' shares of Australia's exports and imports never changed and, more to the point, if there was no trade between the states.

It shouldn't surprise you there's a lot of trade between the states. Nor should it surprise you the mining states import a lot more from the other states than they export to them. The other side of the coin is the other states - particularly NSW and Victoria - export more to the mining states than they import.

This trade between the states spreads the benefits of the resources boom around the continent. In consequence, the much-quoted state final demand figures tend to overstate how well the mining states are doing and understate how well the other states are doing.

That's how the recession furphy got started.

Consider this. According to the latest figures for 2011-12, WA state final demand of 13.5 per cent turned into gross state product of 6.7 per cent, while Queensland's final demand of 8.6 per cent was more than halved to 4 per cent.

By contrast, Victoria's final demand of 2.2 per cent was increased a fraction to gross product of 2.3 per cent, while NSW's final demand of 2 per cent was increased to 2.4 per cent.

SA's final demand and gross product were the same at 2.1 per cent (meaning it neither wins nor loses from the inclusion of international and interstate exports and imports), while Tasmania's final demand growth of zero was increased to gross product growth of 0.5 per cent.

You see how misleading those quarterly state final demand figures are. They exaggerate the true extent of the differences between the states.

So why do the media make so much of them? Because, at a time when the resources boom is doing so much to change the industry structure of our economy, there's much interest in what this is doing to the respective sizes of the state economies.

The quarterly state final demand figures don't give reliable answers to this question, but they're the best that regularly come our way.

But also because the ever-intensifying competition between the news media has prompted them to select their news on the basis of all care but no responsibility. If some information is interesting or controversial it will be published, even if the journalists know or suspect it's dodgy. After all, if I don't do it, my competitors will.

The relative sizes of the six state economies have been changing since federation, partly - but not solely - because of their differing rates of population growth. But, though it's possible to exaggerate the extent to which the resources boom is causing the mining and non-mining states to grow at different rates, the states' relative sizes have been changing particularly rapidly in recent years.

Those recent figures no one bothered to report, known as the State Accounts, showed how the states' shares of overall gross domestic product have changed over the eight years to 2011-12.

In that time, NSW's share has dropped 3.8 percentage points to 30.9 per cent. Victoria's share has dropped 2.6 points to 22.3 per cent.

By contrast, Queensland's share has increased 1.7 points to 19.3 per cent, while WA - which long ago overtook SA in the pecking order - had its share increase a remarkable 5.4 points to 16.2 per cent of overall GDP.

That leaves SA's share falling 0.8 points to 6.2 per cent and Tassie's falling 0.3 points to 1.6 per cent. Its share is now less than the ACT's (2.2 per cent) and only a fraction greater than the Northern Territory's (1.3 per cent).

Whether we like it or not, the shape of our economy is changing.

Wednesday, November 28, 2012

A new economic history of Australia

It drew little comment, but the centrepiece of Julia Gillard's white paper on the Asian century was her target of raising Australia's standard of living - income per person - from the 13th highest in the world into the top 10 by 2025. Considering the three richest economies on the list are the tiddlers of Qatar, Luxembourg and Singapore, it's clear we're already very rich.

Perhaps the reason this grand objective excited so little interest is that, for us Australians, there's nothing new about being in the materialist winners' circle. As Ian McLean, an economic historian at the University of Adelaide, reminds us in a new book, Why Australia Prospered, we joined that company from about 1820, and between 1860 and 1890 we were the richest country of all.

Few countries have been so successful for so long, he says. Some have achieved comparable levels of income only since World War II (think Japan or Italy). Many Asian countries are making good progress in catching up to these levels, though they still have some distance to travel (even South Korea).

McLean reminds us one country has experienced long-term relative decline after having achieved membership of the rich nations' club in the early 20th century: Argentina. And even New Zealand, which tagged along near us for most of the journey, has been falling further behind since the 1970s.

So, in the first major economic history of Australia for 40 years, McLean sets out to explain why we became rich so soon and how we've managed to stay that way for the most part of 200 years.

The story we have in the back of our minds explains it in a phrase: we're the Lucky Country. The Europeans who settled in this vast land had the good fortune to arrive at a place well suited to farming and teaming with valuable minerals. For more than 200 years we've been living off that great luck.

There's no doubt Australia's longstanding prosperity owes a lot to the exploitation of its bountiful "natural endowment". We became a major world producer and exporter of wool as early as the 1820s, and it stayed our principal export earner until the 1950s, save for the 1850s and 1860s when it was supplanted by gold.

McLean says the gold rush was "no flash in the pan". Gold continued to be important to our prosperity for several decades. And we remain a significant world producer to this day.

At the start of the wool boom in 1820, Australia's European population was just 30,000. By the time gold was discovered in 1851, it was up to 430,000. Thanks to the gold rush, in just 10 years it had reached 1.2 million. Most of those people stayed, and by the start of the serious depression of the 1890s it was 3.2 million.

The story of our lucky natural endowment continued with the discovery of many mineral deposits in the 1960s, right up to the Asia-driven resources boom of the past decade. Still today, primary products account for two-thirds of our export income.

But McLean disputes the notion our unending prosperity can be explained simply in terms of our lucky strikes. For one thing, their study of many countries has led modern economists to the conclusion that possession of some valuable resource deposit is almost always a curse rather than a blessing.

It tends to lead to squabbling over who gets the proceeds, corruption, complacency, underdevelopment and stagnation. By contrast, resource-bereft countries such as Singapore or Taiwan seem to have succeeded precisely because they knew they had nothing going for them beside their own efforts.

Clearly, Australia is an exception to the "resource curse" rule. But then we have our erstwhile southern hemisphere twin, Argentina, as a reminder you do have to play your cards right.

Our long prosperity defies another conventional wisdom: colonies get exploited by their colonising power. McLean finds no evidence of significant exploitation by the British. On the contrary.

Unlike some Asian colonies, our economy had to be built from scratch. Who built the foundations and paid for them? The British taxpayer. We benefited from our convict origins. The Brits were expecting it to cost them, and the 160,000 convicts they sent us were selected for their suitability for hard work.

A big part of the reason we got rich so quickly was that such a high proportion of the population was in the workforce. Then there was the advantage of being part of the British Empire trading bloc and the privileged access it gave us to Britain's market.

Self-government came early and bloodlessly in the 1850s.

But McLean gives much of the credit to the quality of our economic and political "institutions" - legal system, property rights, control of corruption, political arrangements and social norms - most of them inherited from the Brits.

The test of our institutions is their flexibility, their ability to adapt in response to changing circumstances and needs. As evidence of flexibility McLean cites the ending of transportation of convicts, a solution to the monopolisation of grazing land by squatters and the pull-back from using indentured islander labour on sugar plantations.

Much more recently you can point to all the economic reforms we undertook in the 1980s and '90s to open our economy to a globalising world. And to our skilful response to the global financial crisis - just the latest of many economic shocks the world has thrown at us.

Australians don't have tickets on themselves as great managers of our economic fortunes, but a look at the record - and at the performance of comparable countries - says we've had a lot more going for us than just luck.

Monday, November 12, 2012

What business needs to learn about politics

The way big business sees it, economic reform has ground to a halt because the politicians on both sides have lost the political will to make the tough decisions. But I think big business must share the blame for the stalemate we've reached.

Business leaders have lost confidence in the Gillard government and, having concluded its days are numbered, are uncharacteristically willing to attack it in public. In private, though, most would doubt an Abbott government would be any more willing to grasp the nettle.

Consider the GST. Despite all the good sense Nick Greiner was talking last week about the need to fix it, both sides refuse even to discuss the topic. It was specifically excluded in the terms of reference for Ken Henry's "root and branch" review of the tax system (which didn't stop him proposing a similar tax with a different name).

It's not hard to see what the problem is. Each side is afraid that, if it showed the slightest interest in considering the topic, the other side will use this as a pretext to launch a scare campaign.

Or, consider the mining tax. Although it's not true the tax raised no revenue in its first quarter, it is true it raised less than expected, mainly because of the fall in commodity prices.

But prices have recovered from their lows in the first two months of the quarter. As well, the nature of the quarterly instalment process means collections are likely to pick up in later quarters.

Even so, it is true that the compromise tax Julia Gillard negotiated with the big three mining companies was both badly designed and too generous to the miners.

Why did she give in to them? Because the opposition had sided with the miners in opposing the original tax and, in their efforts to destroy the Rudd government, the big miners would have given the opposition huge funding in the 2010 election campaign.

One reason the miners were so opposed to the original tax was that the government caught them off guard with a strange tax they didn't understand. This would not have happened had Labor released the Henry report for discussion well before it made up its mind about which recommendations to accept, reject or modify.

So, why didn't it? Because it was so afraid the opposition would run a scare campaign claiming that Labor intended to implement all of Henry's most controversial proposals.

Next, consider company tax. For reasons I can't fathom, big business has its heart set on a cut in the company tax rate. Labor promised a cut of 2 percentage points, but the deal with the miners obliged it to reduce the cut to 1 point.

Then the combined opposition to this from the opposition and the Greens allowed Labor to renege completely. Although all previous cuts to the rate have been funded by the removal of concessions, big business can't agree on which concessions it's prepared to give up.

This has allowed Labor to shelve the idea. And I wouldn't hold my breath waiting for an Abbott government to find the revenue needed to fund a cut.

Finally, consider all the reform the Hawke-Keating government undertook during the 1980s and early '90s: deregulating the financial system, floating the dollar, phasing out import protection, deregulating more industries than you can remember and decentralising wage-fixing.

What do these reforms have in common? They went virtually unchallenged by the Liberal opposition of the day, under the dominant influence of John Howard and John Hewson.

Are you starting to see a pattern? All the reforms that aren't getting up (or, in the case of the mining tax, got badly botched) have become party-political footballs. And almost all the reforms we did get were bipartisan policy - with the GST and the carbon tax as the notable exceptions (although in both these cases the lack of bipartisanship led to inferior policy).

The point is, it's not so much unhappy voters governments fear, it's their political opponents seeking to take advantage of the voters' unhappiness.

What many business people don't understand about politics is the power of oppositions to influence what governments do and don't do. It's rare for governments to make controversial reforms when they know their opponents are waiting to pounce.

The bipartisan support for micro-economic reform lasted throughout the Hawke-Keating government's 13 years, but broke down after Paul Keating's defeat in 1996. Since then, both sides have gone for short-term political advantage at the expense of the nation's longer-term interests.

So, the first lesson big business needs to learn is that it's not enough to pressure the government of the day to show "political will". You must also pressure the opposition to resist the temptation to score cheap political points.

That's particularly the case when it's the opportunism of a Liberal opposition that is discouraging a Labor government from doing what it knows it should.

The second lesson is that big business won't get far until it abandons its code of honour among thieves. That is, when one industry goes into battle with the government to resist a new impost or get itself a special concession, all the other industries keep mum, even though they know the first industry is merely on the make.

Big business looked the other way as the three big miners connived with the opposition to destroy the Rudd government. Its reward was to have its precious cut in company tax snatched away.

Saturday, November 10, 2012

States are correcting earlier mismanagement

In most states around Australia, recent years have seen long-standing Labor governments tossed out and replaced by Coalition governments. In all cases, the new governments have immediately embarked on campaigns to cut government spending. Why?

Is it American-style anti-government ideology? Is it uniform Labor mismanagement across the nation? Could it be some changed feature of the national economy, or just the state governments' irrational pre-occupation with preserving or restoring their triple-A credit ratings?

Turns out to be a bit of most of those.

The Commonwealth Grants Commission, which is responsible for deciding how the proceeds of the goods and services tax are divided between the states, has published an information paper on the changes in state budgets over the 10 years to 2010-11 (which you can find on its website).

It found that, taking all the states and territories together, they ran small overall budget deficits (known as the "net borrowing position") in the first two years of the noughties. Then, for the next five years, from 2002-03 to 2006-07, they ran quite large overall budget surpluses ("net lending position"), meaning they could run down their level of government debt.

Great. But then, for the final four years, they switched back into ever-growing overall budget deficits, rising from $4.3 billion in 2007-08 to a mammoth and unsustainable $15.3 billion in 2010-11.

Can you think of some momentous event about that time that might help explain such a marked deterioration in the states' finances? How about the global financial crisis, which began in August 2007 and reached its climax in September 2008 with the collapse of Lehman Brothers investment bank?

But there was another factor, which got going a bit earlier: the states' rapidly increased spending on capital works. How much does this explain?

Before we go any further, note that these figures relate only to the states' "general government" sector. That is, they don't include the activities or the borrowing of government-owned businesses, such as water boards or electricity authorities.

Also, note that state budgets are heavily influenced by the receipt and spending of grants from the federal government. These receipts are the proceeds of the GST, plus "special purpose payments" - which include federal grants for spending on capital works. Much of the Rudd government's fiscal stimulus went on capital works spending by the states.

Total grants from the federal government account for about half the total revenue received by the states. Until 2007-08, the GST accounted for about 60 per cent of all federal money received; since then its share has fallen to half, a sign it's no longer the "growth tax" it was.

So far, however, this decline in the relative importance of GST money has been offset by increased special purpose payments - though whether this will remain true is different matter.

So next the Grants Commission's information paper strips out all federal payments (and the spending of them) so we can see what's been happening to the states' "own-account" revenue-raising and spending.

It turns out the states' own-account "expenses" - that is, their spending for recurrent purposes - have grown quite strongly relative to the growth in their economies, from 7.3 per cent of gross state product in 2005-06 to 8.1 per cent in 2010-11.

At the same time, however, the states' own-account revenue - composed of mainly of state taxes and receipts from public transport fares and public housing rents - has fallen relative to gross state product, from a peak of 7.8 per cent in 2006-07 to 7.4 per cent in 2010-11.

This explains the marked deterioration in the states' own-account "operating balance" from a surplus of $4 billion in 2006-07 to a deficit peaking at $12.1 billion in 2009-10, before falling to $9.7 billion in 2010-11.

All this suggests there was a degree of mismanagement by the mainly Labor governments in power at the time. While their own-account revenue raising was failing to keep pace with their economies, they were allowing their own-account expenses to grow very much faster than their economies.

I don't have a problem with a growing public sector, but I do have a problem with politicians allowing their day-to-day spending to grow rapidly without being willing to increase taxes to cover it. Particularly at the state level, that's not being "progressive", it's being irresponsible.

To be fair, much of the weakness on the revenue side of their budgets wouldn't have been the state premiers' fault. In particular, conveyancing duty - which accounts for 12 per cent of the states' own-account revenue - made a negative contribution to revenue growth after 2005-06.

This was due to the global financial crisis's effect on the housing market. At the same time the state governments were allowing their own-account operating budgets to deteriorate, they were also stepping up their own-account spending on capital works. This increased from a mere $32 million in 2004-05 to $5.6 billion in 2010-11. (If these figures seem low, it just shows how much of state capital works spending is financed by the feds - in the final year, about two-thirds.)

But if you look at it from the last overall budget surplus of $1.2 billion in 2006-07 to the overall deficit of $15.3 billion in 2010-11, the increase in own-account capital spending accounts for just $2.8 billion of the $16.5 billion deterioration.

So the popular impression that the states are in bother with the credit rating agencies simply because of their need to overcome the widely assumed (but rarely demonstrated) infrastructure backlog seems far from true.

The main problem is borrowing to finance recurrent operations - which, unless states are in the depths of recession, can't be defended.

I don't have much time for Standard & Poor's, Moody's and the other rating agencies. Their dereliction of duty contributed greatly to the global financial crisis, for which they've got away with far too little public censure.

Sometimes I suspect they run an especially hard line on government borrowers to distract attention from the way they disgraced themselves with their paying-customer private sector borrowers in the years before the crisis. They're walking proof that an independent opinion on your financial affairs is not something you can buy.

But in this case they're in the clear.

The main reason for all the belt-tightening by state governments is old-fashioned mismanagement.

Wednesday, November 7, 2012

Climatic adjustment limits our farmers' Asia boom

The first thing to realise about the rise of Asia is that our farmers are about to join our miners in the winners' circle. The second is that climate change and other environmental problems may greatly limit our farmers' ability to exploit this opportunity. The third is that what we see as a looming bonanza, the rest of the world sees as a global disaster.

According to the government's white paper on the Asian century (which, be warned, shares economists' heroic assumption that there are no physical limits to consumption of the world's natural resources), continuing population growth and rising living standards in Asia will cause global food production to grow 35 per cent by 2025, and 70 per cent by 2050.

Rising affluence is expected to change the nature of Asia's food consumption, with greater demand for higher quality produce and protein-rich foods such as meat and dairy products. This will also increase the requirement for animal feed, such as grains. There'll also be demand for a wider range of processed foods and convenience foods, and for beverages, including wine.

But environmental and other problems will prevent the Asians from producing much of the extra food they'll be demanding. Unlike in the past, Asia is likely to become a major importer of food. And, of course, any delay in increasing food production to meet the increasing demand will raise the prices being charged.

You little beauty. "Australia's diverse climate systems and quality of agricultural practices position us well to service strong demand for high-quality food in Asia," the white paper says. After all, Australia is one of the world's top four exporters of wheat, beef, dairy products, sheep, meat and wool.

"As a result, agriculture's share of the Australian economy is expected to rise over the decade to 2025," we're told, something that hasn't happened for many, many decades.

So, a new age of growth and prosperity for Aussie farmers? Don't be too sure. The environmental constraints the white paper expects to bedevil Asian farmers will also limit our farmers' ability to cash in on Asia's growing affluence.

Also published last week was a determinedly positive but franker assessment of our agricultural prospects, Farming Smarter, Not Harder, from the Centre for Policy Development.

It says "winners of the food boom will be countries with less fossil fuel-intensive agriculture, more reliable production and access to healthy land and soils". That's not a good description of us.

The first question is climate change - the problem so many Australians have been persuaded isn't one. Although other countries - including China - are doing more to combat climate change than the punters have been led to believe, we don't yet know how successful global efforts to limit its extent will be.

What we do know is we're already seeing the adverse effects - hurricane Sandy, for instance - and can expect to see a lot more, even if global co-operation is ultimately successful in drawing a line. At present we're focused on efforts to prevent further change; before long we'll need to focus on how we adapt to the change that's unavoidable.

This non-government report says climate change is projected to hit agricultural production harder in the developing world than the developed world - "with the exception of Australia".

"Rainfall is forecast to increase in the tropics and higher latitudes, and decrease in the semi-arid to arid mid-latitudes, as well as the interior of large continents," the report says. "Droughts and floods are expected to become more severe and frequent. More intense rainfall is expected with longer dry periods between extremely wet seasons. The intensity of tropical cyclones is expected to increase."

So, without action to reduce or manage climate risks, Australia's rural production could decline by 13 per cent to 19 per cent by 2050, it says.

And it's not just climate change. "One of the biggest challenges for Australian agriculture is that our soils are low in nutrients and are particularly vulnerable to degradation ... every year we continue to lose soil faster than it can be replaced."

The productivity of broadacre farming used to grow by 2.2 per cent a year; since the early 1990s it's averaged just 0.4 per cent. Australian farmers use a lot of fertilisers and fuel, the cost of which is also likely to rise strongly. And that's not to mention problems with water.

Meanwhile, those who worry about how the world's poor will feed themselves - or about the political instability we know sharp rises in food prices can cause - don't share our hand-rubbing glee at the prospect of Asia's greatly increased demand for food.

Almost as bad as high food prices are highly volatile prices. The three world price spikes in the past five years each coincided with droughts and floods in major food supply regions. Extreme weather events are likely to become even more frequent. (The growing diversion of grain to produce biofuels is another contributor to higher food prices.)

After the food price spike in 2008, 80 million people were pushed into hunger. But the growing concern with "food security" is often a euphemism for resort to beggar-thy-neighbour policies: countries that could export their food surplus to other, more needy countries decide to hang on to it, just in case.

The Asians' attempts to continue their (perfectly understandable) pursuit of Western standards of living are likely to be a lot more problem-strewn than the authors of the white paper are willing to acknowledge.

Monday, November 5, 2012

Asia white paper assumes away environment

The most glaring weakness in the Prime Minister' s white paper on the Asian century is its failure to factor in the high likelihood that mounting environmental problems will stop Asia continuing to grow so rapidly as well as limit our ability to take advantage of what growth there is.

To be fair, most of the environmental problems that could trip up Asia s economies and ours do rate a mention in the bowels of the 300-page document.

But it doesn t join the dots. Asia s environmental problems are dismissed merely as among the various challenges to be overcome bumps along the road. As for our own environmental problems, the government s existing policies have them well in hand.

And it would be unfair to single out the Gillard government as unwilling to face up to the seriousness of our problems with the natural environment and start integrating them into its forecasts and projections.

That s just as true of almost all economists and business people. While most economists (and some business people) are prepared to acknowledge particular environmental problems climate change, water, soil, fish stocks, biodiversity they re not prepared to see them as symptoms of a much bigger problem: we may be reaching the physical limits to continued growth in natural resource use.

So, just like the white paper, they continue to put worries about environmental problems in a box marked environment , which they keep separate from the box marked economy , where they do their forecasts and longer-term projections of economic growth.

It s an uncontroversial statement that the global economy the production, consumption and other economic activities of humans exists within, and depends on, the natural environment, the global ecosystem.

And it s obvious to anyone with eyes that certain economic activities are doing damage to the ecosystem, which is already rebounding on the economy in the form of costs and disruption (hurricane Sandy, for instance). It s not hard to believe these costs and disruptions are likely to multiply unless we start organising the economy very differently.

It thus makes all the sense in the world for economists to integrate the environment and the economy when thinking about what the future holds. So why don t they? Because they never have, and find the idea pretty frightening.

Economists standard way of thinking about the economy effectively assumes away the environment. That s because their conventional model which has changed little in the past 100 years is built around the prices charged in markets, whereas most environmental assets clean air, clean water, good soil, reasonably reliable weather can t be bought and sold in markets.

Thus most of the costs and benefits generated by the ecosystem are external to the model and so liable to be overlooked. Schemes such as the carbon tax are attempts to put a price on greenhouse gas emissions and so get them into the price mechanism (and the model).

So you can bolt bits of the environment onto the model, but you have to do it case-by-case, which is hardly satisfactory. As Professor Herman Daly has said, if the survival of your society is external to your model, you probably need a new model .

The funny thing is, if you re still not sure why so many scientists doubt it will be physically possible for Asia to grow as big as economists project, the clues are all there in the white paper. To put things in context, at present the developed world accounts for just 15 per cent of the world s population, but 51 per cent of gross world product.

The 19 per cent of the world s population living in China has a standard of living equivalent to 20 per cent of America s. The white paper expects that to reach 40 per cent in just 13 years.

For India and Indonesia, accounting for a further 21 per cent of the world s population, their standard of living could also double, from 10 per cent to almost 20 per cent. And, of course, living standards in other parts of Asia are also supposed to be rising rapidly, meaning more than half the world s population is applying to join the profligate rich club.

Have you any idea what that would mean in additional use of the world s energy and other natural resources?

The white paper advises that, in the 19 years to 2009, Asia s energy consumption more than doubled and its share of world energy consumption jumped from 25 per cent to 38 per cent. China is now the world s biggest energy consumer.

Having gone from consuming less than half as much energy as the US in 2000, China now consumes slightly more. It accounts for almost half the world s coal consumption. It s the world s largest consumer of steel, aluminium and copper, accounting for about 40 per cent of global consumption for each. It s predicted to be 90 per cent dependent on imported oil by 2050.

In 2009, fossil fuels accounted for about 82 per cent of Asia s energy mix. Asia accounts for about 40 per cent of global greenhouse gas emissions up from 31 per cent in 2001. China recently overtook the US as the world s largest emitter.

The white paper happily assumes effective global action to limit climate change will be forthcoming, so makes no allowance for it in its projections.

It s not the done thing for economists to imagine we could ever run out of natural resources. Prices may rise a bit, but this will merely call forth the solution to the problem, whereupon prices will fall back. And every textbook leaves you thinking this process happens seamlessly.

So, no need to worry. Our faith in unending growth remains unshaken.

Saturday, November 3, 2012

How Asia is catching up with the rich West

Asia's transformation into the world's most dynamic economic region has been a defining development of our time. The pace and scale of its rise have been nothing short of staggering.

That's the story according to Julia Gillard's white paper on the Asian century, and it's right.

"Over the past 20 years, one third of the world's population has re-engaged with the global economy and more are set to do so," the paper says. "Living standards for billions of people in Asia have improved at a rate not previously experienced in human history."

Just between 2000 and 2006, about a million people were lifted out of poverty every week in East Asia alone, we're told.

Japan, South Korea, Singapore and, more recently, China and India doubled their income per person within a decade. Some went on to repeat this achievement two or three times.

By contrast, it took Britain more than 50 years to double its income per person during the Industrial Revolution of the late 18th and early 19th centuries.

Why so long? Because the Industrial Revolution was driven by the invention of new technology and it took a while for new inventions to come along and for their use to spread through the economy.

These days, the economy sitting at this "technological frontier" is the US. In principle, the fastest pace at which America's income per person - its material standard of living - can grow is determined by the pace of what today we call "innovation". And that's not fast - say, 2 per cent a year.

So with the rise of Asia we're seeing a phenomenon economists call "catch-up and convergence". Because all the improved machines and better ways of doing things have already been invented and are sitting on the shelf, so to speak, it's not hard for all the countries well back from the technological frontier to catch up with the leader by employing the new productivity-boosting technology. As they do, their standard of living converges on the leading economy's.

This is what happened in the West in the first 30 years or so after World War II. The economies of Europe (and Japan) grew very strongly and closed most of the gap between their living standards and America's.

Now that process of catch-up - and the global spread of the latest technology - has shifted from the developed countries to the developing countries. Japan was the first, followed by South Korea, Hong Kong, Singapore and Taiwan, with China getting going in the 1980s and India in the 1990s. More will follow.

Of course, transforming your economy from developing to developed can't be as simple as taking new technology off the shelf, otherwise all the poor countries of the world would be growing as fast as Asia is.

So how have the Asians done it? What have they got right that the others haven't?

The various countries' success hasn't followed a simple recipe, the paper says, but some common patterns have emerged in recent decades.

Many economists explain Asia's rise mainly in terms of its switch from the post-war policy of "import replacement" (seeking to grow by protecting your industries from competition with imports) to export-led growth.

If, as part of this, you allow foreign multinational corporations to set up factories in your country, they bring in the capital need to pay for building those factories, as well as access to the latest foreign technology and the knowledge of how to use it, which ends up being transferred to local technicians and managers and spreading to local firms.

But that's not how the white paper tells it. "Nearly all the high-performing Asian economies deliberately set out to support prosperity by investing in people, building capital and undertaking institutional change, including expanding the role of markets," it says.

Asia's young people enjoyed marked improvements in their access to education and its quality as governments invested in their youthful populations and dramatically transformed their education and training systems.

"With the benefits of a good education and employment-creating reforms, large numbers of young people have become productively employed as they reached prime working age."

Open global trading systems (created by the successive rounds of multilateral reductions in protection under the predecessor to the World Trade Organisation, to whose trade-promoting rules China signed up in 2001) and the construction of vital infrastructure to reduce transport costs have been drivers of integration between Asia and the rich economies, but also between the Asian economies themselves.

Intricate regional production networks have emerged, along with increased flows of "intermediate goods" (components) between countries in the region. Specialisation within the region, and the consequent economies of scale, have given the region a powerful advantage, particularly in manufactures.

Here's a point that ought to be obvious to older Australians - since they've been able to observe it over their lifetimes - but too few people understand: Asia's most successful economies have continually evolved.

"As incomes have risen in population-dense economies such as Hong Kong, Japan, South Korea and Taiwan, and as their labour-intensive activities have become less competitive, Asia's high performers have refocused their production on new areas of consumer demand - developing domestic markets and specialising in high-skill activities."

What oldies should have noticed is the way, over the years, the production of simple, labour-intensive goods - such as clothing, footwear and toys - has migrated from one country to another.

Why? Because, contrary to the propaganda of the unions and the Left, Asian workers get their cut from being exploited by wicked "transnational corporations".

As countries' economies grow, workers' real wages rise.

As well, a fair bit of the prosperity is ploughed back into raising the education level of the workforce.

Eventually, the workers' labour gets too expensive to continue using them to produce simple labour-intensive goods, so production of such goods shifts to the next, undeveloped Asian country.

In the first country, production shifts to using the more-skilled workforce to make more sophisticated manufactures. As well, more of the country's production shifts from export to being bought by the now-more-prosperous locals.

The white paper predicts, as this evolutionary process continues, within 13 years - 2025 - China will be the world's biggest economy, India will be third, Japan forth and Indonesia 10th. China will account for a quarter of gross world product and Asia for almost half.

Thursday, November 1, 2012


Talk to Jobs Australia National Conference, Manly, Thursday, November 1, 2012

The last time I spoke to your national conference, many moons ago, I offered some confident predictions about the outlook for the labour market. It seemed to go down quite well, but turned out to be hopelessly wrong. So this time I propose to do something quite different, something more philosophical, something I haven’t done before, even something a bit naughty. For many months I’ve been reading and ruminating on a question of motivation: how do we get people to do their job well? The trouble is, though I’ve come to some tentative conclusions, I haven’t yet finished my search and haven’t yet decided what the answer is. Despite that, I’m going to give you a progress report on my ruminations to date.

The question of how you get people to do their job well is one facing every manager, but it’s also a key question for public policy. Governments and their bureaucrats seem increasingly concerned to ensure people are doing their jobs in the way the pollies and their advisors think they should. For instance, they’re concerned to ensure the organisations contracted by them to deliver job services to the unemployed do so efficiently, effectively and accountably. So I hope you can see why I thought my topic to be of more than passing interest to all of you.

But governments’ concern with the topic goes a lot further than the management of contractors. It’s clear, for example, the Gillard government - like many governments - is quite dissatisfied with the performance of schools and teachers, and is using a wide range of strategies in the hope of achieving improvement: the regular, national assessments of literacy and numeracy, the publication of those Naplan results and much other data on the MySchool website, the offering of incentive payments to schools and teachers etc. Another case: the state governments respond to the public’s belief that the sentencing of criminals is too lenient by reducing judges’ discretion. A different case is occupational health and safety. We don’t want workers’ health to be endangered in the workplace, but what’s the best way to get employers to exercise the necessary care?

So what do I think about all this? Well, as I say, I’m still making up my mind. But let me give you my conclusions so far. They boil down to six.

First, I accept we need accountability and transparency from organisations and their employees.

That’s particularly true for government agencies, which operate with authority (and funding) derived from the public, and also for outfits delivering services on behalf of the government. If you’re handling taxpayers’ money you have to account for it, in a way that people working in the private sector need to be supervised but not be held publicly accountable to the same extent. Of course, it’s not just the money you handle, it’s also what you do to discharge the duties you were charged with.

Second, I agree with the modern trend to greater measurement of performance.

One of the slogans that accompanies the new mania for measurement says: you can’t manage what you don’t measure. I’m not sure that’s true, but it does contain an element of truth. Actually, the hard part of being a manager is managing the unmeasurable.

Putting these first two propositions together, I don’t accept the argument of the teachers’ unions that, because measures of schools’ performance are capable of being misunderstood by parents (or misused by the media), they should not be made public. Most of these measures have been calculated by education departments for many years and used for their own management purposes, but kept strictly confidential to all but the insiders. The fact is that all statistics - every one of the thousands produced each day by the Bureau of Statistics, from the national accounts to the CPI - are capable of being misunderstood and misused. That’s a reason for educating people in their correct interpretation, not a reason for the performance of elected governments and their agencies to escape public scrutiny. It’s not an argument for keeping the public in the Mushroom Club. Having said that, however, I must add a qualification:

Third, I have grave doubts about the modern management fad of using KPIs (key performance indicators) in the attempt to ensure people do their jobs well.

It is true that measures of performance (‘metrics’ in the fashionable business jargon) are capable of being misinterpreted, even by managers, let alone by outsider amateurs and a sensation-seeking media. Most managers know little about the rules and the pitfalls of statistical interpretation. It may be that when workers are employed to perform simple, repetitive tasks - workers on a factory production line, for instance, or those employed in data entry - you can get away with using numerical targets to ensure a satisfactory rate of output, provided you combine it with some form of quality control.

But, these days, the satisfactory performance of most skilled jobs simply can’t be measured with a few key numerical indicators. Nor is the quality of people’s performance easily checked. This is because satisfactory performance of the projects people work on has too many dimensions. It would be impractical to attempt to measure every dimension, and some dimensions may not be capable of measurement. In such circumstances, supervising the quality of people’s performance will also be difficult. Even where a person’s job is to process a number of cases each day or each week, it may be easy to count the number of cases they get through, but much harder to allow for the differing difficulty of those cases, as well as monitor how well they were dealt with. That’s true even of lowly workers in a call centre. While most of the problems they deal with may be routine, we all know from experience how easy it is to ask a question that’s beyond the operator’s pay grade or to be offered confident assurances we know, or soon discover, to be wrong. We all know how unhappy we can be with the experience, even when we eventually got what we wanted.

Numerical indicators of performance are particularly unsatisfactory when the task involves dealing with individuals - because people and their problems come in so many shapes and sizes. At least three-quarters of Australia’s workforce works in the services sector, and most of those jobs involve delivering services to individuals. Am I starting to ring any bells with your own circumstances?

But the fact that performance so often can’t be satisfactorily assessed using PKIs is just the start of the problem. The deeper problem is that PKIs are so easily manipulated - so easily ‘gamed’. If the satisfactory performance of my job has, say, five dimensions, and you slap a KPI on as many as three of them, rest assured I’ll meet my targets. But I’ll do it by cannibalising the two dimensions you haven’t measured. This kind of behaviour is rife and it’s the reason I regard the use of KPIs as a fad that management will soon see to be a snare and a delusion.

Early in the days of Paul Keating’s national competition policy, someone came up with the idea of encouraging better performance by the state governments by means of what I think was called ‘benchmark competition’. The idea was to publish each year, for each of the states, a host of key indicators of their performance in all their areas of responsibility (courts, prisons, hospitals, schools etc). The public would be able to see which states were doing better and which were doing badly, and this would encourage the states to try harder. At first the relevant state bureaucracies complained the figures weren’t on a comparable basis, so much effort was put into making sure they were. But someone who’d been close to the process told me the figures - which are still produced each year - are utterly unreliable because of each state’s efforts to manipulate their indicators.

This is why I have much sympathy with the teachers’ argument that a quality education has a lot more dimensions than just the literacy and numeracy so regularly measured by Naplan. Put too much emphasis on Naplan scores and you will get schools ‘teaching to the test’ and, in the process, neglecting those dimensions of a quality education not being measured. Whether this yields a net benefit to students is a question no one bothers to measure - assuming they could.

From the developed world’s unhappy experience with monetarism and money supply targeting in the 1970s emerged something economists call Goodhart’s Law, which holds that ‘any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes’. That’s what’s wrong with KPIs.

It follows that attaching monetary incentives to KPIs is equally foolish. But I would go further and say:

Fourth, I have grave doubts about the equally fashionable practice of using performance pay to try to ensure people do their jobs well.

This is not just because good performance is hard to measure, but also because money is a bad motivator. Thanks to the limitations of their model, economists unconsciously assume money is the only motivator. And, perhaps because of their own materialism, business people easily assume monetary incentives are likely to be most effective. But the obvious truth is that people are also motivated by a host of non-monetary motivations, ranging from the pursuit of power and social status to the satisfaction of working hard and doing a job well. Many people have a deep commitment to doing their job to a high standard - for the benefit of customers, but primarily for their own satisfaction.

There are two problems with performance pay. One is that the more I’m motivated just by money, the more I’m likely to cut corners, sacrificing quality. The other is that studies by psychologists show monetary incentives drive out non-monetary motives. Once you’ve trained people to do things just for the money, any subsequent decision to abandon performance pay will lead to a deterioration in performance.

Fifth, I also doubt the effectiveness of the main alternative to monetary incentives, the imposition highly prescriptive rules and regulations.

This is the approach beloved of governments and bureaucrats. David Thompson tells me the rules the department imposes on providers of job services run to 3000 pages. So I imagine this is the main way the government tries to get you guys to do your jobs well. It also applies to governments’ attempts to oblige judges to impose harsher sentences.

You probably don’t need me to tell you why this approach doesn’t work well, either. As well as burdening people with a lot of red tape and compliance costs, it limits their freedom to exercise their discretion in responding to the peculiar circumstances of each of the cases they deal with. It stifles, and therefore wastes, people’s use of their experience and expertise in discharging their responsibilities to the best of their ability. It assumes the people making rules that fit the general case know better than practitioners on the ground dealing with specific cases that may or may not fit well with the general case. It also assumes practitioners aren’t to be trusted. And rules, too, can be gamed by people who’ve been discouraged from doing their best.

Consider the industrial relations tactic of ‘work-to-rule’. Work-to-rule demonstrates that it’s actually very hard to design rules on paper than work smoothly in practice, partly because circumstances may differ so much from case to case. It shows that well-functioning organisations are organisations that honour the spirit of rules rather than the letter, that turn a blind eye to rules that don’t work well.

But if PKIs, monetary incentives and prescriptive rules don’t work in getting people to do their jobs well, what does?

This I’m still working on. But I do have some clues.

Sixth, rather than trying to control people with rules or performance targets, or bribing them to do a good job, we should be aiming to produce well-trained and well-motivated workers, free to exercise their discretion in meeting the needs of the widely varying cases that come before them.

Psychologists tell us intrinsic motivation is superior to extrinsic motivation. That is, it’s better to encourage people to do things for their own sake, rather than for the external rewards they bring. When people take a pride in doing their job well, you get better performance than using rules or whips or bribes.

Sociologists tell us people’s behaviour is heavily influenced by something most economists and business people are oblivious to: social norms of acceptable behaviour. Studies show making people attend courses on ethics does little to make their behaviour more ethical. There will be exceptions but, in practice, people tend take their ethical standards from the behaviour of those around them. If most people around me cheat, I’m likely to cheat. If most people around me work hard, I’m likely to work hard. And if my group habitually works hard, it’s likely to come down hard on any individual within the group who slacks off. The thing about ‘norms of acceptable behaviour’ is that they usually involve the imposition of informal sanctions on individuals whose behaviour the group regards as unacceptable. You don’t get fined, you get gossiped about, chipped and, in the extreme case, sent to Coventry. Humans are such social, ‘groupish’ animals - we are so pre-programmed to want to ‘fit in’ - that such informal sanctions are usually highly effective in achieving adherence to group norms.

There’s an old debate in monetary economics over ‘rules versus discretion’. The best position is probably a half-way house - discretion within a set of fairly loose rules - but I believe leaving people with discretion to use their expertise to make the best decisions to fit the particular case is likely to maximise the chance they will be motivated to do their best work. Tight rules are de-motivating.

What we need to bolster this, however, is a group norm - a ‘culture’ - that we all work hard, we all do our best to meet our clients’ needs, and if we cut corners we do it to fit a client’s needs, not for our own convenience. How do you introduce such a culture where it doesn’t exist? How do you strengthen such a culture if it isn’t strong enough?

That’s what I’m still working on. One thing I do know is that it has to start at the top. Not surprisingly, bosses are hugely influential in affecting the attitudes and behaviour of the people working for them. But they’re influential not so much in the programs they introduce and the pep talks they deliver but in how they behave. As business people say, you have to walk the talk.

Another clue lies in the original meaning of the word ‘professional’. What does it mean to be professional? These days, it may mean you play sport for money, not just the love of the game. More commonly, it means well-trained, highly proficient. But its original meaning is instructive: it used to mean putting the client’s interests ahead of your own. In other words, the complete antithesis of doing a job just for the money. To say, I’m a member of a profession, is to say I put clients first.

I suspect the culture we need to introduce into organisations to lift their performance is old-fashioned professionalism. And though I’m still working on ways to do that, I do know this: if you can get the work culture right - get the norm of acceptable behaviour right - it will tend to be self-reinforcing, without need for KPIs, performance pay or highly prescriptive rules.