CHINA'S ECONOMY: AN UPDATE

Comview 2016

As you may have noticed, earlier this year I went on a journalists’ junket to China, which has rekindled my interest in the rise of the Chinese economy and its influence on our own economy. I know this is a subject of interest to many economics teachers and their students, so I’m going to start with China’s effect on our economy and a discussion of ChAFTA, then evaluate the policies used to promote growth and development in China and, finally, look at the influence of globalisation on China’s economy - though, in the case of China, it makes more sense to look at the influence of China on globalisation. I probably won’t get time to cover all the material in my full paper, so it would be worth reading full version after you get home.

China’s effect on our economy

As I’m sure you know, for many years Australia’s largest trading partner - taking the most of our exports and supplying the most of our imports - was Japan. But Japan’s relative stagnation since the 1990s and China’s remarkable economic reawakening since the late 1970s, caused China to overtake Japan as our major trading partner in 2007.

Even before the start of the resources boom in 2003, China accounted for more than 8 per cent of our combined exports and imports of goods and services. Twelve years later, in 2015, China’s share is more than 22 per cent. Now China’s $86 billion of our exports gives it the largest share, at 27 per cent, while our imports from it of $64 billion give it the largest share at 18 per cent. Note that, as with Japan, we have a perpetual trade surplus with China.

Between China, Japan, South Korea, India, the ASEAN countries and more, Asia takes about 70 per cent of our exports. So we have been highly successful in enmeshing ourselves with the fastest growing region of the world. This has been good for us, since our major trading partners (weighted according to their shares of our trade) are growing by about 4 per cent a year, compared with less than 2 per cent for the developed countries. Of course, having so many eggs in the Asian basket does mean we’d be hit hard if China’s economy were to have a “hard landing”, to which you’d have to attach a reasonable probability. We’re by no means the only country with China as its major trading partner; it’s also true of many Asian economies. Much trade is “intra-regional”. Note, too, that the US is China’s largest trading partner, while China is the US’s second biggest (after Canada) - and its biggest creditor. So any trade war between the US and China would be so mutually destructive as to make it unlikely.

Our economy is highly complementary with China’s. We specialise in exporting the minerals, energy and other primary products they need; they specialise in exporting the manufactures we aren’t good at making ourselves. The past 20 years have seen China become manufacturer to the world, causing slower growth in the manufacturing sectors of all the developed countries.

China’s protracted period of rapid economic growth, which started slowing only about five years ago, combined with its huge size - its population is now almost 1.4 billion - could not help but have involved huge consumption of minerals and energy. China presently accounts for more than half the world’s annual consumption of iron ore and steaming coal, and more than 40 per cent of aluminium, copper, nickel, zinc and lead. So it was inevitable that China’s rapid growth in the years leading up to and immediately after the global financial crisis would have big implications for a major resource exporting country like ours. We benefited greatly from the huge rise in coal and iron ore prices - which peaked in 2011 - and from the consequent boom in mining and natural gas construction activity, which peaked in 2013 and is still falling back.

It’s a mistake to think mineral commodities are pretty much the only thing we sell the Chinese.  At present, resources account for about two-thirds of the total value of exports to China, leaving 21 per cent for other goods (mainly rural) and 11 per cent for services.

However, China is now facing challenging times. Its annual rate of growth has slowed - to 6.7 per cent over the year to September, 2016 - simply because, when you are coming from a low base, it gets harder and then impossible to maintain a very high rate of growth. At 10 per cent a year, the economy doubles about every seven years; at 6.7 per cent, it doubles about every 10 years.

But China must now move on to a new stage of economic development if its rate of growth isn’t to slow a lot further. Its exports of low-value manufactures have probably reached saturation point in the world market, and its growing prosperity means that real wages are rising strongly (about 8 per cent a year versus 3 per cent inflation) and eroding profit margins.

Because China remains a socialist market economy, the central government uses successive five-year plans setting out its goals, strategies and targets. As summarised by Asialink, the present, 13th five-year plan focuses on increasing China’s competitiveness through more efficient and increasingly advanced manufacturing on the east coast, attracting labour-intensive manufacturing to central provinces, and increasing domestic demand.

As expressed in the recent joint Australia-Chinese expert report, Partnership for Change, China is shifting its growth drivers from investment, exports and heavy industry to consumption, innovation and services. Chinese production is shifting from a model based on adaptation and imitation of goods, services and technologies developed elsewhere, to a model based on domestic innovation. Part of this involves a shift from labour-intensive, low-tech, low-value manufacturing to more advanced, high-tech, high-value manufacturing. This has already started.  Over the 20 years to 2015, low-tech manufacturing’s share of China’s total exports of goods has shrunk from almost half to less than 30 per cent.

So, at a time when our economy must adjust to the end of the resources construction boom and find new sources of growth, China must also make a (more fundamental) transition from investment and exports to consumption and imports. In this challenge our economies aren’t quite the same complementary fit, but there is scope for us to supply the ever more sophisticated demands of China’s rapidly expanding middle class, even if in more intensified competition with other developed countries.

China’s greater demand for imported services certainly fits with our need for greater services-led growth in production and employment. And we are already showing success. Chinese tourist visits to Australia have risen from 350,000 visitors in 2009 to 1.2 million visitors in 2015, and are forecast to exceed 2.5 million visitors by 2024. In 2017 China is expected to overtake New Zealand as our largest source of overseas visitors.

With exports to all countries of almost $20 billion a year, education is our third largest export category (behind iron ore and coal), while tourism is the fifth largest. Chinese student enrolment numbers have risen from 140,000 to 170,000 in the past three years, and HSBC bank forecasts they could exceed 280,000 by 2020. China is the largest source of international students in Australia, accounting for more than a quarter of overall international enrolments. Chinese students spend more during their time in Australia than other international students, only partly because they tend to stay longer. China’s growing middle class mean a growing market for business services such as accounting, legal and financial services, and its ageing population will see rising demand for healthcare. As a whole, business services have risen by a similar amount to tourism and education in recent years.

Most of the growth in exports of “other goods” involves foodstuffs. This had been driven by grain exports, but these have fallen off in the past couple of years. But exports of “finer foods” - such as meat, dairy, sugar and edible oils - have risen. China recently became our largest export market for wine, at almost $500 million over the year to September, up 50 per cent on the previous year.

It is common for our major trading partners to want to invest in our economy, particularly to make direct investments in those of our industries that supply the exports they are buying. Since Australia has been a “capital importing” economy from the beginning of white settlement, this has always been acceptable to our governments, despite recurring popular concerns about “selling off the farm”. Our major trading partners have often been running current account surpluses, making them keen to find profitable investment opportunities in other countries.  There has been some resistance to China’s foreign investment in Australia but, as yet it represents less than 5 per cent of total stock of foreign investment, coming seventh behind the US (27 per cent), Britain (16 per cent), the rest of the EU (16 per cent), Japan 6 per cent), Singapore and Hong Kong. Chinese investment in residential property in Sydney and Melbourne has probably added to upward pressure on prices, but much has been in new apartment developments, which should add to supply as well as demand.

The China-Australia Free Trade Agreement

Like most economists, I am dubious about the benefits of the bilateral preferential trade agreements known misleadingly as “free trade agreements”. They tend to divert trade from to the favoured country from other, cheaper suppliers, while adding to administrative costs through complicated “country-of-origin” rules. The officials negotiating them seek maximum concessions from the other side while making minimum concessions of their own, whereas economic theory says the main efficiency benefits come from reducing your own barriers to imports, rather than achieving reductions in other countries’ barriers to your exports. In practice, many of the preferential agreements made in recent years have involved only modest concessions on either side.

However, the ChAFTA agreement which came into effect in December 2015 was more significant than the other agreements we have reached. This is mainly because China, having been a member of the World Trade Organisation only since 2001, had many more reductions in tariff protection it was able to make than other, more developed economies. China has made trade agreements with several other countries, but its agreement with us is said to be the most comprehensive and liberalising arrangement it has entered into.

China agreed to eliminate immediately or phase out tariffs on Australia coal, alumina, beef, dairy, sheep, pork, live animals, horticulture, wine and seafood. No reduction in tariffs on sugar, rice, wool, cotton or wheat were agreed. Restrictions on Australian direct investment in Chinese businesses have been reduced. For our part, Australia agreed to phase out its 5 per cent tariff on imports from China of various manufactured goods, including electronics and whitegoods. In theory, we liberalised our restrictions on Chinese direct investment in Australian firms, but several highly publicised proposals have been rejected on claimed grounds of national security. It is commonly observed that ChAFTA creates much opportunity for Australian firms to take advantage of in coming years, but it remains to be seen how much they do.

 Policies used to promote growth and development in China

 China has a long and illustrious economic history. It was a major centre of trade more than 2000 years ago with the establishment of the Silk Road in about 200 BC, which connected Asia with Europe and Africa. The Chinese are credited with inventions such as the compass, gunpowder, fireworks, silk, noodles, moveable-type printing and papermaking.

In the centuries since then, however, China became very inward-looking, limiting its trade and contact with other countries. Even so, economic historians estimate that by 1820 China accounted for about a third of world GDP, with India increasing the two countries’ share to almost half. So China and India are former super powers. Today they’re not emerging economies, but re-emerging economic giants. What happened after 1820, of course, was the growth of the European and new-world economies such as America and Australia, following the spread of the Industrial Revolution. By 1970, China’s share of world GDP had fallen to less than 5 per cent (with India’s share even smaller).

After China’s Communist revolution of 1949, led by Mao Zedong, the 1950s were spent expropriating private property and establishing a planned economy. After an initial surge in growth, the economy began to stagnate. But all that began changing after 1978, when Mao’s successor, Deng Xiaoping, began the far-reaching market-oriented reforms that have brought China’s economy to where it is today. He instituted what he called “socialism with Chinese characteristics”, but economists call a “socialist market economy” - one in which a big sector of state-owned enterprises (SOEs) exists in parallel with market capitalism and private ownership - both local and foreign.

The 1980s saw much reform of China’s agricultural sector as the Russian collectivist system was dismantled and farmers incentivised by being allowed to sell their surplus production on the open market. The result has been a huge improvement in the productivity of China’s farms, such that China is the world’s largest producer of agricultural products - including rice, wheat, pork and fish - even while millions of rural workers have moved to the city to take factory jobs. Thus China’s industrialisation and urbanisation have gone hand in hand. Now more than half the Chinese population lives in cities.

The 1990s were devoted particularly to the growth of China’s manufacturing industry. It followed the Asian strategy of development first pursued by Japan and South Korea: exploiting the country’s abundance of cheap labour to produce and export low-value manufactures such as textiles, clothing and footwear, and toys. The strategy of export-led growth was promoted by keeping the exchange rate low and attracting financial capital, technology and the transfer of know-how by encouraging foreign investment.

This strategy does most to explain China’s rapid growth over the past 40 years, with annual growth averaging 10 per cent for about the middle 30 of those years. Those 30 years saw the size of China’s GDP multiply by about 48 times. With China’s population growth limited until very recently by its one-child policy, this meant a rapid rise in material living standards, as measured by income per person.

According to the World Bank, more than 500 million people were lifted out of poverty as China’s poverty rate fell from 88 per cent in 1981 to 6.5 per cent in 2012, as measured by the percentage of people living on the equivalent of US$1.90 or less per day in 2011 purchasing power parity terms. Because this is a measure of absolute poverty, however, it has not prevented some people’s incomes rising a lot faster relative to other people’s. China’s official Gini coefficient for the distribution of income is 0.46 (compared with Australia’s 0.33), but some unofficial estimates put it even higher.

Combine these decades of rapid growth with China’s population of 1.36 billion - the largest in the world - and it’s not surprising China is now the second largest economy in the world, when measured in nominal exchange rates, or already the largest when exchange rates are adjusted for purchasing power parity (because $US1 buys a lot more in China than it does in America).

Measured using PPP, China’s share of world GDP is about 16 per cent. It is already the world’s largest trading nation and largest producer of manufactures.

 According to standards set by the World Bank, China already has 300 million people with household incomes high enough to be considered “middle class”. However, when the World Bank compares countries rather than households, and looks at countries’ level of income per person, China is still classed as a middle-income country - no longer low income, but not yet high income. Its income per person is about $US8000 using nominal exchange rates, or about $US15,000 after adjusting for purchasing power parity, thus making it only the 84th richest country in the world. Many developing countries - particularly in Latin America - have managed to make it from poor to middle-income, but been unable to make the transition from middle-income to high-income. China must now break out of this “middle-income trap”, as economists call it.

By land area, China is the fourth largest country (after Russia, Canada and the US, followed by Australia as fifth), covering about 9.6 million square kilometres. It has three levels of government: the central government based in Beijing, 34 provincial-level governments and many local governments. Although we view it as one economy, according to Asialink it can also be viewed as a decentralised collection of several regional economies, with large wealth imbalances between rural and urban populations. The eastern provinces, which contain most of the manufacturing, are the wealthiest. Central China is more agriculture-focused and not as wealthy, although low-end manufacturing is increasingly moving into the region. Western China is the least economically prosperous region, although it has significant natural resources. The three wealthiest and most economically important regions are all on the east coast: the Pearl River Delta, close to Hong Kong; the Yangtze River Delta surrounding Shanghai; and the Bohai Bay region near Beijing.

Influence of globalisation on China’s economy

The story of how, since 1978, China has grown to become the world’s second or first biggest economy is all about how it opened up to trade and investment with a globalising world and, in the process, added greatly to the globalisation process and its effects on many other countries, not least of which is Australia.

China’s economy in the 1970s was poor and slow-growing mainly because it was cut off from the rest of the world. So when its leaders decided to introduce elements of the market system, they were consciously opening up to trade with the rest of the world - imports and well as exports - and to foreign investment in their economy and the acquisition of the latest technology and know-how.

One major landmark in the opening up process was China’s admission to membership of the World Trade Organisation in November 2001. This involved China agreeing to abide by all the rules governing trade between member countries and dismantling certain of its tariffs and restrictions on imports. More recently, China has concluded bilateral “free” (that is, preferential) trade agreements with South Korea, ASEAN, New Zealand, Switzerland, Pakistan and, of course, since 2015, with Australia.

But not all countries have found their economies to be such an easy fit with China’s. Unlike Australia, many developed countries have large manufacturing sectors, which have been threatened and then diminished as China has become the world’s largest trading and manufacturing nation, exporting not just low-value items but, increasingly, more advanced products such as steel and motor cars. Although the manufacturing workers of China have benefitted greatly from increased employment and rising wages, the opposite is true for many workers in developed countries.

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How to get better, not smaller, government

Whether it's a week early or not, it looks a safe bet that this year's budget will do little more than keep the wheels of government turning for another 12 months. If so, it will confirm our worst fears that neither side of politics is capable of improving things.

I hope I'm wrong, but it now seems that the sweeping tax reform we were long promised by the Coalition – with everything on the table, and a white paper to follow a green paper - has shrivelled to some minor tinkering to pay for a minor tax cut.

Which brings us back to the budget's primary macro-economic purpose, achieving "fiscal sustainability". We've been assured – as usual, by leak – that any improvement in revenue estimates arising from the seeming recovery in iron ore prices will be allowed to reduce the budget deficit, not used to fatten the tax cuts or otherwise buy votes.

Considering all the crocodile tears the Coalition shed over "debit and deficit", it's the least Malcolm Turnbull could do.

The Coalition has done little to restrain government spending in its first term for two reasons, one political and one economic. The political reason is that the public and the Senate held Tony Abbott to his last-minute and utterly unneeded promise not to cut any of the key areas of government spending.

The economic reason – which was perfectly sensible and actually began under Labor – was that with the economy growing at well below its "trend" (average) rate, now was the wrong time to weaken it further by raising taxes or cutting government spending.

With forward-looking trend growth now reduced to 2.75 per cent a year and the economy growing by 3 per cent in 2015, we should be getting on with budget repair.

So both those restraints are now inoperative – or should be. It's one thing to avoid nasties in a pre-election budget; it's quite another to lock yourself in for another term with promises not to cut this or that spending, or not to adjust taxes.

Similarly, it's all very well for Turnbull's supporters to say he needs his own mandate to establish his legitimacy and authority with his fractious backbench; it's quite another for him to gain a "mandate" that doesn't include a licence from the electorate to make the improvements we need.

So a key issue will be how much reform Turnbull promises not to make and how much leeway he leaves himself to do what needs to be done.

But after the monumental setback of Abbott's first budget, I worry not just about the character strength of our politicians, but also about the quality of the advice they're getting from the econocrats of Treasury and Finance and the heads of other departments.

One thing the bureaucrats should understand is that the ideological push for lower government spending is a snare and a delusion. It's never gonna happen, because the public won't accept it and there are no pollies mad enough to try.

The key to good spending management is to accept that the goal should be not smaller government, but better government. Delude yourself that we'll soon be seeing smaller government – that there are vast areas of things governments will stop doing – and you're more susceptible to the kind of short-sighted, mindless cutbacks that often involve false economies, mere cost-shifting or savings that don't stick, of which we saw so much in the first Abbott budget.

But accept that we need better government – that government will always be with us, with ever-growing responsibilities and spending – and you see more clearly that the task is to identify and correct specific instances of excessive or ineffective spending – with which the budget no doubt abounds.

You slow the rate of spending growth, reducing the incidence of what the public thinks of as "waste" (it may look like waste to me, but not to whoever's income it's adding to), thus giving taxpayers better value for money and helping to reduce the resistance to paying tax.

Focus on better government and you realise that the "no-brainer", set-and-forget, don't confuse me with the details, approach favoured by econocrats has an appalling record of failure.

You don't bother to think hard about the peculiar characteristics of the service being performed, nor do you wonder about the wisdom of letting private firms "sell" heavily subsidised government services, you just resort to generic, magic answers such as imposing an "efficiency dividend", "getting the incentives right" and making the provision of public services "contestable".

Economic shibboleths are no substitute for detailed knowledge and careful analysis.

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THE ‘CRISIS’ IN HEALTHCARE FUNDING, AN ECONOMIST’S VIEWPOINT

Talk to UON Master of Clinical Medicine residential workshop, Sydney, Saturday, March 12, 2016

I want to talk to you about the widely perceived crisis in the funding of healthcare, and do so from a wider, more economic perspective than you may normally be exposed to. I should say I don’t claim to be an economist, just a journalist who writes about economics.

As we were told in the Abbott government’s commission of audit, for example, federal government spending on healthcare - covering in particular the medical benefits scheme, the pharmaceutical benefits scheme, the national health and medical research council, the regulation of private health insurance and grants towards the states’ public hospitals - is among the fastest growing categories of government spending, growing faster than the growth in federal tax collections. The growth in healthcare spending was thus, we were told, “unsustainable”.

Every five years, the federal Treasury produces an intergenerational report that seeks to project federal budget spending over the coming 40 years, and it invariably confirms healthcare as likely to be the fastest growing spending category over that period, growing at a rate far faster than the likely growth in tax collections and thus contributing greatly to an ever-growing budget deficit.

In a few months’ time the NSW state Treasurer will produce her latest intergenerational report, and it, too, will show spending on public hospitals and other healthcare growing much faster than other state government spending categories. I remember the first state intergenerational report showing that health spending is likely to grow so fast that it alone could absorb all of the likely state revenue before we got to the end of the next 40 years. Clearly, this would be an intolerable and, indeed, politically impossible thing to allow to happen, so something fairly drastic will have to be done to ensure it doesn’t.

The politicians - federal and state - find it easiest to explain this projected rapid growth in healthcare spending - all of it based on the assumption that present policies remain unchanged - as produced by the ageing of the population. When you examine the projections more closely, however, you find the main cause of growth isn’t ageing, but the projection for another 40 years of relatively recent rates of growth in spending on medical procedures, drugs and prosthetics. The real cause of the rapid growth turns out to be the ever-increasing cost of advances in medical technology. New and better drugs and procedures almost invariably cost more than the drugs and procedures they supersede. Part of the escalation process is that, when doctors become more familiar with, and confident in, some new operation, they become willing to perform it on older or less healthy patients. Another key ingredient in the process is the public’s demand for immediate access to all new and improved drugs and procedures. If it’s better, we want it. And we want it now. Subsidised, of course.

So this is the healthcare funding crisis, as widely conceived by econocrats, many private-sector economists and virtually all politicians. There is no limit to the public’s demand for government spending on a host of worthy things, of which healthcare is just one. But there is a limit to the taxing capacity of governments, and we’ve pretty much reached that limit. Most people believe they’re already paying too much tax. The present federal government believes that collections from federal taxes can’t be allowed to exceed 23.9 per cent of gross domestic product - which was the ratio’s average over the eight years between the introduction of the GST in July 2000 and the onset of the global financial crisis in 2008. It was the application of this rule that caused the intergenerational report to show an ever-rising budget deficit. Clearly, this can’t be allowed to happen. Governments can’t go on borrowing more year after year just to help finance the day-to-day business of government for another year.

All this explains the pressures I’m sure you’ve experienced to limit the growth in spending in your own hospital, or the growth in government rebates for services delivered in private practices. These have become ever-more pressing over the years and they’re likely to continue and intensify in coming years. This being so, I’ve been assured we’ve seen the demise of the mentality I call “the divine right of doctors”. God has called me to heal the sick, and so I must be free to incur whatever expense in tests and procedures I judge to be necessary in discharging my sacred duty. No mere mortal - certainly not someone who isn’t even a fellow medical practitioner - can be allowed to limit my freedom of action. An economist sees this as an argument that the “budget constraint” - the inescapable truth that resources are limited, so none of us can have everything we want - should apply to everyone except doctors. If the medicos’ open cheque takes up too much of the tax revenue available to the government, force people doing something less important than medicine to take the hit.

It shouldn’t surprise you to be told that this attitude is not accepted by anyone who isn’t a doctor. Those other people’s attitude is that health care is vitally important, but so too are education, the protection of law and order, the provision of public transport and decent roads, and all the other things governments do. The government’s finances can only be kept under control by setting limits on how much can be spent in each spending category, which need to be adhered to as much by people in the health system as by people in other parts of the public sector. As I say, I’ve been assured by insiders that this is now widely accepted by doctors.

So much for the conventional wisdom on the healthcare funding “crisis”. I have to tell you that I don’t accept that conventional wisdom. There are probably other economics-types who share my alternative way of looking at it - particularly health economists - but you don’t often hear from them. You get to that alternative perspective by conducting a thought experiment: what would be economists’ attitude to the rapid growth in healthcare spending if all of that spending were occurring privately? If the health industry wasn’t so heavily subsidised by government?

The answer is, in that case, economists wouldn’t be in the least bit concerned about the rapid growth in healthcare spending, nor even interested in the topic. Why not? Because this would merely be the expression of individuals’ personal “preferences” as to how they chose to spend their income. Nor would economists be surprised that consumers had made this choice. They recognise health care as a “superior good” - goods (or services) that make up a larger proportion of consumption as incomes rise. In other words, as our real incomes rise over time, we spend a high proportion of the increase on superior goods, so that the superior good’s share of our total consumer spending keeps rising over time. Intuitively, it makes much sense for us to treat healthcare as a superior good. There are few human motivations more basic than our desire preserve our health and stave off death. What more natural than for us to spend more on healthcare as we get richer? Do economists disapprove of the high priority we give to improving our health and longevity? Of course not.

End of thought experiment. The reality is that the great majority of the nation’s total spending on healthcare is spent in the first instance by governments, then recouped from us by means of general taxation. The services provided by public hospitals are essentially “free”, while most medical consultations and pharmaceuticals are heavily subsidised. This is supplemented by a heavily regulated, subsidised, mainly voluntary form of taxation known as private health insurance.

Why is healthcare so heavily subsidised by government? The simplest explanation is for what economists would call “equity” reasons. We don’t want to see people dying or suffering ill-health simply because they can’t afford the cost of unsubsidised healthcare. Like every other developed country bar the US, we’ve decided that access to a reasonable standard of healthcare must be “universal”.

But you can also make what economists would call an “efficiency” argument for universal healthcare. Although healthcare doesn’t fulfil the textbook requirements for it to be a “public good” - it’s not “non-rivalrous” and “non-excludable” - it can be described as not just a superior good, but also a “merit good”. That is, governments should ensure it is made available to all because, like other goods such as education, it carries with it “positive externalities”. Just as all of us benefit economically from the compulsory education of others - including workers who’ve never been to university benefiting from the education of those who have - because it means we live in an economy with a better educated and more highly skilled workforce, so the rest of us benefit from living in an economy with a healthier (and thus more productive) workforce and from reduction in the spread of communicable deceases. It may also be the case that universal provision brings economies of scale.

It’s never a good argument that government subsidisation of a particular activity or industry is a good thing because it creates a lot of jobs and generates a lot of income. That’s because all spending - public or private - generates jobs and income, so the real question is whether we’re spending on the particular things that would benefit us most. Even so, this is the place to remind you that Australia’s hybrid, public and private healthcare system is one of our biggest industries. Judged by its share of total employment, what the Bureau of Statistics calls “health care and social assistance” is our biggest industry by far, accounting for almost 13 per cent of all jobs. And don’t let any economic ignoramus tell you the private sector part of the industry is “productive” but the public sector part isn’t.

All this being so, there’s no reason we should regard the relatively rapid growth in the nation’s spending on healthcare as a bad thing. Indeed, quite the reverse. It’s a predictable and desirable consequence of the advance of medical science on the one hand and our growing prosperity on the other. So why the depiction of healthcare spending as “unsustainable” and a “crisis”? For two reasons - one bad and one good.

The bad reason for the crisis-mongering arises from an attitude that views government budgets purely from the tax side. It starts with the assumption that taxation is fundamentally a bad thing, that we’re already paying too much of it, that there can be no justification for increasing taxes and, indeed, we should be working towards reducing them. This attitude is a convenient combination libertarian political philosophy and populism - voters never like the sound of new or higher taxes. The push for lower taxation and resistance to higher taxes can be sustained only by assuming that much government spending is wasteful: it’s being spent doing things governments don’t need to do, much of it involves “churning” - taking money off people so you can give it back to the same people - or involves outright waste, so that you could end that waste without doing any harm to anyone.

This is exaggeration at best, wishful thinking at worst. Since it’s widely accepted that there should be such heavy government involvement in and subsidisation of healthcare spending - since no one is seriously arguing that healthcare should be left to the private sector - the question we should be asking is: is it clear the public wants increased spending on new and better procedures and drugs? I think it is clear the public is getting what it wants, with the budget used to distribute the ultimate burden of that spending in a way we’re reasonably content with. If so, the only problem is the extreme unwillingness of our politicians - on both sides - to confront voters with the consequences of their preferences: if you want more spending on better healthcare you’re welcome to it but, as with everything else in life, you’ll have to pay more for it. We should stop allowing the veil of the budget to allow people to dissociate cause from effect.

That’s my basic position: the growth in healthcare spending is only “unsustainable” for as long as our leaders lack the courage to ask us to pay more for it.

But there is also a good reason for disquiet about the present state of healthcare funding. The economists’ training - including the anti-government attitude implicit in their neoclassical model - makes them suspect the high level of government involvement in healthcare is resulting in inadequate and distorted economic incentives and a fair bit of waste. So a second question we should be asking is: And are we confident the public is getting value for the money we spend?

My answer is no, not really. I believe there is plenty of scope to make savings in spending by reducing the “rents” being extracted from the system by drug companies, chemists and suppliers of prosthetics, by improving the coordination of care, putting more effort into preventive medicine, overcoming the obstacles to electronic, portable health records, better management of hospitals, updating the medical benefits schedule, reducing the reliance on subsidised fee-for-service, and so forth.

I wasn’t at all impressed by the measures proposed in the Abbott government’s first budget, which were aimed at cost-shifting - to patients and to state governments - rather than cost control. The $7 co-payment was framed as an efficiency measure - it was intended to make people think twice about going to a GP because there was now an upfront payment involved - but it could easily have proved to be a false economy if it discouraged patients who really needed to see a doctor and to get working on their medical problem.

That measure was beaten off, but not so far the plan to save $80 billion over 10 years by moving to less adequate indexation of federal grants to the states for their public hospitals and schools (with hospitals accounting for $57 billion of the $80 billion, and most of the saving starting from 2017). There’s no way the states can save that amount of money through genuine efficiencies. But nor are simple cutbacks in levels of service - with lengthening waiting lists and times - a politically sustainable solution.

But these ham-fisted attempts to limit healthcare spending don’t mean there aren’t sensible, better thought-through and more painstaking ways to achieve genuine efficiencies and savings. The point to remember, however, is that any success in achieving efficiency savings won’t reduce public sector healthcare spending, nor even stop it continuing to grow. That’s because the public’s demand for early access to the latest advances in medical technology is most unlikely to abate. The greatest likelihood is that healthcare spending will continue growing in real, per-person terms for as long as we can imagine. This means the primary reason for seeking greater health efficiencies is to deliver taxpayer-patients greater value for money. But the best the taxpayer (and the politicians) can hope for is that increasing efficiencies lead merely to healthcare spending growing at a slower rate.

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China still our advantage in a dismal world

We are living in an era of exceptionally weak growth in the world economy. We can now look back and see that era began after the global financial crisis in 2008. We can look forward and not see when the era will end. It could be years, for all we know.

Naturally, this continuing global weakness has its effect on us. So we shouldn't blame ourselves for our own weaker growth relative to our earlier performance. Rather, we should recognise that, relative to the other developed economies, we've been doing pretty well.

But we do need to remember that, compared with the others, we have a secret weapon: our strong economic links with China.

Nigel Ray, a deputy secretary of Treasury, spelt out the unusual features of the world we've entered in a speech this week. He notes that "global growth has struggled to regain sustained momentum post-global financial crisis, and global aggregate demand remains weak".

This is despite monetary policy (interest rate) settings in nearly all the major economies remaining "extraordinarily accommodative", and global public debt increasing since the crisis.

Official forecasters have continued to downgrade prospects for global growth, he says. The International Monetary Fund downgraded its forecast in its January update - the 17th downgrade in five years.

Now get this. Slower world growth has been accompanied by a number of trends that can be seen across the global economy: slower growth in international trade, weak business investment, slower productivity growth, slower population growth in the advanced economies, low inflation, and lower expectations about future inflation.

Wow. That's the sort of poor performance you expect to see briefly at the bottom of a world recession, not as a semi-permanent state.

We knew that slower growth in the working-age population as a result of population ageing would mean slower economic growth, but now official forecasters in other countries are also reconsidering their view of long-run "potential" growth in gross domestic product (just as we've done recently, cutting it from 3 per cent to 2.75 per cent).

For the other countries, "this partly reflects the ongoing legacy of the global financial crisis - such crises have long-lived effects on investment in productive capital and on labour markets, increasing structural unemployment and lowering labour force participation rates".

In other words, if business goes for some years under-investing in new and improved capital equipment, this diminishes the economy's production capacity. And when some workers go for years unable to find another job, they tend to lose their skills and the self-discipline that goes with having to turn up to work on time every day and do as you're told.

But it's not only the after effects of a protracted recession. Ray says recent estimates by IMF economists suggest that productivity growth was slowing in the advanced economies even before the GFC.

More recently, we've noticed that the "convergence" between the emerging and the advanced economies (as the emerging economies catch up by growing at a much faster rate than the advanced countries) that we've seen since the turn of the century is showing signs of stalling.

If that happens, it means slower global economic growth and could have other undesirable consequences.

It happened that Reserve Bank deputy governor Dr Philip Lowe gave a speech in Adelaide on the same day, adding to Ray's description of the strange state the world economy finds itself in.

Lowe noted that, although the official interest rate in the United States has been increased for the first time in nine years, the Bank of Japan has unexpectedly moved its rate into negative territory.

In doing so it joined the European Central Bank, the Swiss National Bank, the Swedish Riksbank and the Danish central bank with negative interest rates. And there's an expectation in various countries that yet further monetary easing will take place.

Lowe says that, in earlier decades, it was very rare for central banks to worry that inflation and inflation expectations were too low.

"Yet today we hear this concern quite often, and the 'unconventional' has almost become the conventional," he says.

But back to China and the special advantage it gives us in a dismal world. Ray says we have a higher proportion of our exports - about 32 per cent of our exports of goods - going to China than any other advanced economy does.

Twenty years ago, China's economy was less than a third of the size of America's. Today it's the largest economy in the world when you measure it according to "purchasing power parity" (as you should).

China's rate of growth may be slowing, but it remains one of the fastest growing economies in the world.

What many foreign observers don't seem to understand is that, just as we are "rebalancing" our economy from mining-driven to other sources of growth, so the Chinese are doing something similar, shifting from growth based on heavy industry, investment and exports, to growth based on service industries, consumer spending and imports.

It's possible the Chinese economy could falter as it makes this transition, but they'll get there in the end and this is why it's possible for us to shift from selling them mainly minerals to selling them the goods (fancy Western foodstuffs) and, particularly, the services their growing middle class demands.

We've been talking about this for years, but now it's actually happening. Ray says China is already our largest destination for services exports, taking about 14 per cent of them last financial year.

China is now our second largest source of overseas visitors, and their visitors spend far more than average. More than a million Chinese tourists arrived in 2015.

But get this: those million visits represented only about 1 per cent of China's overseas tourism market. They are so big relative to us that just a tiny share of their market is a big deal in helping us keep growing.

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Where the jobs will come from

It's a question doubting customers have been asking me through the whole of my career: but where will all the jobs come from? We worry about jobs, convinced there's never enough of them.

Whenever we're in a recession, with unemployment high and rising, people simply can't see how we'll ever get it down again.

In the more recent resources boom, a lot of people got jobs in faraway places helping to build new mines and natural gas facilities, but we knew that wouldn't last.

Mining now accounts for about 10 per cent of the value of the nation's production – gross domestic product – but it still employs only about 2 per cent of the workforce.

When the three foreign car makers announced in 2013 that they'd be ending Australian production later this year or next, the familiar cry went up: where will the new jobs come from?

It was a question I used to find hard to answer, but now I don't. When I started in this job more than 40 years' ago, there were 5.8 million people in the workforce. By now it's more than doubled to 11.9 million.

So the jobs did come, despite 40 years of worrying that they wouldn't. Where did they come from? I could work out from the figures how many came in which particular industries, but I'll skip to the bottom line: virtually all the extra 6 million jobs came from the services sector.

Where will the jobs be coming from in the years ahead? Same place. Indeed, they already are.

Our most recent worry has been where our economic growth would come from now coal and iron ore prices are falling and no new mining construction projects are taking the place of completing projects.

But the evidence is coming in. We're experiencing strong expansion in parts of the vast services sector, which is generating lots of extra jobs.

Whereas mining – and farming and, these days, even manufacturing – are capital-intensive, and so provide few jobs, service industries are labour-intensive, and so provide lots of 'em.

From a job-creating perspective, the trouble with physical things – "goods" – is that it's been relatively easy to use machines to replace workers, whereas you still need a lot of people to provide services, even when those people are given better machines to help them.

The other trouble with goods industries is that there's a limit to how many things – clothes, cars, fridges, laptops – you want to own. Time has shown there's almost no limit to the number and kinds of services we'd like others to perform for us.

Did you know there's such an occupation as "lactation consultant"? There used not to be, but there is now.

These are the reasons why almost all the extra jobs being created are in the services sector.

Last year, total employment grew by a very healthy 300,000 jobs, more than half of them full-time.
Research by Professor Jeff Borland, of the University of Melbourne, has found that more than 90 per cent of these jobs occurred in the private sector.

This private sector growth was concentrated in NSW and Victoria, whereas the growth in public sector employment was concentrated in Queensland and South Australia.

But where did the additional jobs come from? Fully a third – 100,000 – were in (the mainly private sector parts of) healthcare. Then came 75,000 in businesses providing professional and technical services, almost 50,000 in retailing, more than 40,000 in financial services and more than 30,000 in administrative and support services.

The thing to note about that list is that while some of those jobs would have been low-skilled, many – particularly those in professional services and healthcare – would have been high-skilled, well-paid and intellectually satisfying. But even the lesser-paid jobs would have been clean and safe.

So don't turn up your nose at services sector jobs.

And get this: the extra jobs went disproportionately to older workers. Although people aged 45 and above account for only 31 per cent of the overall workforce, they accounted for 57 per cent of the growth in jobs.

But wait, there's more. Though we keep hearing about the growth in the quantity of our mineral exports as the new mines come on line, we've heard far less about the growth in the quantity of our exports of services, particularly education and tourism. (We "export" services when foreigners come to Oz to receive them.)

Our services exports have benefited greatly from the fall in our dollar, which has made them cheaper to foreigners.

Last year, spending by international students on course fees, accommodation, living expenses and recreation grew by 13 per cent to more than $19 billion. Spending by foreign tourists in Australia rose by 11 per cent to almost $16 billion.

What's more, our lower dollar has encouraged many Aussies to take their holidays at home rather than abroad. We now have more tourism money coming in than going out.

You well know it was exports to China that did most to fuel the resources boom. What nobody's bothered to tell you is that it's China and its growing middle class that's doing most to boost our exports of education and tourism services.

Don't underestimate the contribution services are making to "growth and jobs".

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Let’s stand against misleading modelling

Many people have been left with red faces following their part in last week's disastrous intervention into the negative-gearing debate by forecasters BIS Shrapnel. Let's hope they all learn their lesson.

This isn't the first time that "independent" modelling purchased from economic consultants has been used by vested interests to try to influence government decisions. Nor the first time the questionable results have been trumpeted uncritically by the media and misrepresented by the side of politics whose case it happens to suit.

But BIS Shrapnel's late entry into this dubious game has come at a time when the game's credibility is wearing thin and qualified observers are more willing to go public with their critiques of the quality of the modelling, the plausibility of its assumptions and the internal consistency of its findings.

As is common practice, various of the BIS Shrapnel model's findings were expressed in a highly misleading way. "Rents will rise by up to 10 per cent ($2,600) per annum", for instance, doesn't mean rents will rise by up to 10 per cent a year. It actually means that, by the 10th year, annual rents will be up to 10 per cent higher than they otherwise would be. Not nearly as bad as it was made to sound.

The first lesson for BIS Shrapnel is that when you publish commissioned modelling, but agree not to disclose who commissioned it, you attract a lot more criticism and scepticism. When it's not possible for those on the other side of the debate to say "they would say that, wouldn't they", they examine your assumptions and methodology a lot more critically.

Another lesson is that when what you're modelling looks like it's a party's policy but isn't, you should say so up front, not in mitigation after that party has denounced you from the rooftops.

Similarly, "unfortunate typos" saying $190 billion when you meant $1.9 trillion get you hugely adverse attention. Your "trust me, I'm an economist" line implodes.

I can't remember when so many economists of repute have gone out of their way to attack a modeller's findings, and done it so bluntly.

John Daley, of the genuinely independent Grattan Institute, referred to the report's "convoluted logic", "manifestly ridiculous predictions", "outlandish" and "fanciful" claims, and "implausible" and "unjustified" assumptions. It was "nonsense on stilts".

The lesson for other economic consultants is that the days when you could produce for a client a bit of happy advocacy posing as objective econometric analysis, and have the rest of the profession look the other way, are coming to an end.

There's now a far greater likelihood that other economists or economic journalists will subject your assumptions, methodology and findings to scrutiny and make their conclusions public.

There's now much greater familiarity with the standard tricks of the trade, such as misuse of the Bureau of Statistics' "input-output tables" to exaggerate the "indirect effects" of some measure; saying "employment will fall by X" when you really mean "the growth in employment will be X less than otherwise", or presenting effects that build slowly over many years as changes that occur fully in the first year and occur again in each subsequent year.

The lesson for relatively new treasurers trying to establish a reputation for economic competence, and the ability to explain complex economic concepts persuasively, is you'll never do it if you act like a political brawler and latch on to whatever third-party modelling seems to be going your way.

A treasurer looking for respect doesn't identify himself with any modelling before his experts – the economists in his department, not the ambitious young politicos in his office – assure him it's kosher.

If I was a subscriber to an Australian newspaper that led its front page with a wide-eyed account of BIS Shrapnel's findings as though they were established fact, only to have them exposed the same day as highly debatable, I wouldn't be impressed.

The lesson for the economics profession is that the modelling they value so highly is too often being used by other economists to mislead rather than enlighten. The reputation of models and modellers is being trashed, and with it the credibility of the profession.

If economists don't want to be regarded by the public as charlatans, they should consider the call by the Australia Institute – a noted debunker of misleading modelling – for a code of conduct for economic modelling. It would "require key assumptions to be revealed, context and comparison to be provided, and the identification of who, if anyone, commissioned the work".

Since the profession has failed to act, the institute wants the code implemented by governments.

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Why the economy is growing faster

So, the shock, horror economic news of the week was something good. The national accounts showed the economy grew a lot more strongly during the last part of last year than anyone was expecting.

Whereas economists – both on the official and the market side – were expecting growth in real gross domestic product of 0.4 per cent or less during the December quarter, leading to growth of 2.5 per cent for the year, the Australian Bureau of Statistics came up with figures of 0.6 per cent and (thanks to upward revision of growth in the September quarter) 3.0 per cent for the year.

Why? Because the statisticians found stronger growth in consumer spending – particularly spending on services – than people were expecting, as well as stronger exports of services.

In other words, our domestic economy – indeed, not just our internal economy but the household sector of our economy – is a bigger part of our destiny than many imagine.

It should be a lesson to those who assume that problems in other economies immediately translate to problems in our economy.

Or that problems in financial markets – particularly the sharemarket – immediately translate to problems in the "real" economy inhabited by you and me. That once the bad news starts, all the news is bad.

The lesson holds even though this week's news relates mainly to a period that began five months ago and ended two months ago, whereas the bad news about China and the sharemarket and all the rest came in the new year.

The first conclusion to draw from this week's accounts is that, if we enjoy a long period of exceptionally low interest rates and a significant fall in the value of our dollar, these forms of stimulus will eventually get the economy growing faster.

The second conclusion is that, thanks to the help of low interest rates and a low dollar, the economy's transition from mining-led growth to growth in the rest of the economy is proceeding satisfactorily.

The national accounts showed business investment spending falling by 3.3 per cent in the December quarter and by 10.1 per cent over the year, with most of that explained by the sharp drop-off in mining and natural gas construction.

On the other side of the transition, the first effect of low interest rates was to encourage a surge in the buying and selling of existing houses, leading to a rise in the prices of those houses and the building of a lot of additional houses.

Spending on building new homes and altering existing ones grew by 2.2 per cent in the quarter and by 9.8 per cent over the year.

Consumer spending grew by 0.8 per cent in the quarter (following upwardly revised growth of 0.9 per cent in the September quarter) to show healthy growth of 2.9 per cent over the year.

Explaining this isn't easy. Let's turn to the "household income account" - which means we switch from quoting real (inflation-adjusted) changes to quoting nominal changes.

We know that household income wouldn't have been growing too strongly because, although a lot more people got jobs in the December quarter, wage growth has been very low. Household income grew by just 0.4 per cent in the quarter.

And household disposable income grew by less than 0.1 per cent, mainly because payments of income tax grew by 1.2 per cent in the quarter.

And yet consumer spending grew by a remarkably strong 1.2 per cent during the quarter (that figure's nominal, remember).

How was this possible? It happened not because households "dipped into their savings" as was mistakenly reported, but because they chose to reduce the amount of what they saved from the quarter's disposable income.

According to the accounts, the nation's households reduced their saving during the quarter by $2.9 billion, dropping it to $19.5 billion. This means the net household saving ratio fell from 8.7 per cent of household disposable income to 7.6 per cent.

Remember that the estimate of household saving is calculated as a residual (income minus consumption), so it can be distorted by any errors in the other items in the sum.

It's not hard to believe the rate of saving has fallen, because for the past four years it's been edging down from its post-financial crisis peak of 11.1 per cent at the end of 2011.

Even so, last quarter's drop of more than 1 percentage point seems very big, about double the size of the biggest previous quarterly falls. It may be revised to a smaller drop.

The best explanation for households' falling rate of saving is that people are less worried about their debts and about keeping their jobs, with rapidly rising house prices in most cities leading them to feel wealthier than they were.

The decline in the rate of saving as house prices rise is pretty convincing evidence of a "wealth effect" helping to bolster consumer spending at a time when household income isn't growing strongly.

And the wealth effect coming via house prices helps tie the strength of consumer spending back to the period of low interest rates and its ability to stimulate spending in different ways.

The news of faster growth in production also fits with the already-known strong growth in jobs – particularly in the later part of last year – and modest fall in the rate of unemployment.

It makes the good news we've been getting on the labour market easier to believe because it's now more consistent with the story we've been getting from the national accounts.

Annual real GDP growth of 3 per cent is a fraction higher than the economy's newly re-estimated trend or "potential" growth rate of 2.75 per cent. And this above-trend growth is what's usually required to have the unemployment rate falling – as it has been.

Of course, whether growth stays at or a little above trend this year isn't guaranteed.

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Doctors share blame for a sick budget

Some of my best friends are doctors. These days, I even have in-laws who are doctors. I've just become a grandad and my tiny grandson stands a fair chance of ending up as a doctor, too.

But I'm still a journo, and have to do my job. So let me let me adapt something Kerry Packer said about a youthful Malcolm Turnbull: never get between a doctor and bag of money.

If you wonder why it will be so long before we get the federal budget back into surplus, doctors are part of the reason.

If, as Scott Morrison keeps telling us, the trouble with the budget is a spending problem, not a revenue problem, the government's decision last week to greatly increase our spending on defence has just made the problem a lot worse.

That's the problem with saying government spending is the problem. Politicians – of all stripes – are much keener on increasing spending than on reducing it.

A lot of the growth in spending – especially if you include the state governments – is coming from spending on healthcare. Part of it's the ageing of the population, but most of it's the higher cost of new pharmaceuticals, prosthetics and medical procedures.

There's actually nothing terrible about that. If we're getting a little more prosperous each year, what's more natural than that we choose to spend a fair bit of that increase on improving our health?

If so, the problem isn't our spending, it's our reluctance to pay for it. Which means the real problem with the budget is the aversion of pollies on both sides to confronting voters with that simple truth: if you want more spending on better healthcare you're welcome to it but, as with everything else in life, you'll have to pay more for it.

The problem with the debate about spending and taxing is that government budgets are so huge – about $430 billion a year, and a lot more if you add in the states – with so many taxes spent on such a multitude of things – that it's easy for each of us to lose our sense of cause and effect, in a way we'd never do with our own, household budget.

But to say that spending on healthcare should and will continue growing strongly – so the pollies had better learn to live with that fact – is not to say that every dollar spent on health is a dollar well spent.

Every doctor I know tells me there's plenty of waste in the health system. Governments should be trying to find and eliminate that waste, thereby giving taxpayers better value for money, as well as slowing the rate of healthcare spending's inexorable rise.

Here I have to tell you that, under the greatly improved leadership of federal Health Minister Sussan Ley, and after the public's summary rejection of the harebrained idea of imposing a $7-a-pop patient co-payment on GP visits, the Health Department is making a much better effort to identify and remove waste.

Trouble is, just because a payment is judged unnecessary doesn't mean there isn't someone for whom that payment is part of their income. Threaten to take it away and all hell breaks loose as they fight to protect that income. Especially if they're a doctor.

Late last year the Turnbull government proposed saving $650 million over four years by removing bulk-billing incentives for pathology services and reducing them for diagnostic imaging.

The boss of the nation's most powerful union, aka the Australian Medical Association, was out of the blocks within moments, prophesying death and destruction.

Doctors would have no choice but to impose their own charges on patients, many of whom would struggle to afford them, leaving some poor people declining to get the tests they needed.

Yeah, sure.

Some years ago the Labor government tried to save money by cutting the rebate for eye operations. The ophthalmologists created an enormous stink, telling every little old lady they could find they'd have to start charging thousands for a cataract removal and urging them to write to their local member.

It worked. The Labor government beat a hasty retreat. Some years later, a doctor mate told me everyone in medicine knew the opthos were raking it in. The fees in the medical benefits schedule had been set long before the procedure had become highly automated, allowing surgeons to do far more operations in a day.

Everyone in medicine knew this, but while the opthos were bludgeoning the government, they kept their mouths shut – a practice known as "professionalism".

It's a similar story with pathology rebates. Advances in automation have made the rebates far higher than they need to be – which is why the special bulk-billing incentives aren't needed.

And because automation also offers big economies of scale, we now have about three-quarters of the nation's pathology tests being done by just two big companies, both listed on the stock exchange – a small fact the AMA boss didn't feel he needed to mention.

For once, this isn't about greedy specialists. This is a fight to protect the excessive profits of two big listed companies. But please still write to your local member.

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Change of Senate guards on gate to economic reform

Sometimes it's things that don't seem to have anything to do with economics that have the biggest effect on economic policy.

The proposed changes in voting arrangements for the Senate, which Malcolm Turnbull is pushing through Parliament with as little scrutiny as possible, are a case in point.

If they're passed – as it seems they will be – they're likely to make life a lot easier for lobbyists, who'll have a much smaller list of Senate parties to get around – in both senses.

Another fear about Turnbull's voting change – being supported by the Greens and Nick Xenophon, but opposed by everyone else in the Senate – is that it will lead to a decline in political competition by raising the barriers to entry by other, newly emerging parties.

The Nobel Prize winning economist Kenneth Arrow, first came to prominence with his "impossibility theorem".

He proved mathematically that when voters have to choose between three or more options, no system of ranking their preferences can produce a single, indisputably best order of precedence.

That is, there's plenty of room for argument over which voting system, while not being perfect, is better than the others.

This is why we need time – the usual Senate public inquiry would do – to hear from the experts and examine the properties of the voting system one side of politics has come up with and wants to ram through.

If the Coalition has proposed a move to optional preferential voting, allowing people to express their preference for up to six party groupings, it's a fair bet it believes such a system will advantage it over its Labor rival.

If the left-leaning Greens and centrist Xenophon party are happy to give the Coalition what it wants, it's a fair bet that's because the deal leaves room for their comfortable survival, while raising the drawbridge against the emergence of new minor-party rivals of either leaning.

The benefit to the Liberals is that their coalition (their joint voting ticket) with the Nationals, and the greatly reduced scope for the emergence of new, right-of-centre minor parties, minimises the wastage of right-leaning votes, whereas the lack of a coalition agreement between Labor and the Greens leaves significant scope for the wastage of left-leaning votes.

That's the point about optional preferential voting – it leaves a lot of votes being wasted. And this is how it greatly reduces the possibility of new minor parties gaining a foothold.

When Xenophon first got himself elected to South Australia's upper house, he did so with a primary vote of less than 3 per cent. It was winning a seat that allowed his profile to grow and ensure much higher primary votes in subsequent (federal) elections.

Similarly, it was a quite small initial primary vote that allowed Bob Brown to get known and eventually spread the Greens to all states.

Turnbull's proposal doesn't change the requirement that, to win a seat in a half-Senate election, you need to amass 14 per cent of the votes in your state. For a full-Senate election after a double dissolution, the quota falls to 7.6 per cent.

If the indication of preferences becomes optional – meaning many people won't bother – the hurdle facing future Xenophons and Browns will be almost unreachable. They'd need a primary vote not far short of the quota.

Behavioural economists know that the way you "frame" a proposition greatly influences how people respond to it. Turnbull has framed his thus: if you want to put an end to micro-parties gaming the system and getting people with a primary vote of as little as 0.5 per cent elected, support my reforms.

Sorry, non-sequitur. You can agree with the first part – as I do – without accepting that Turnbull's solution is the only one, or even the best available.

A better solution – one that ended gaming by micro parties without stymieing all democratic change – would be to retain the present preference system but simply add the rule that candidates getting a primary vote of less than, say, 2 per cent, would be excluded from election and their preferences redistributed.

Turnbull and his minor-party collaborators claim that the rush to get his Senate changes into law by March 17, and for them to take effect immediately, is independent of his threat to call a double dissolution if his anti-union legislation is blocked.

But if he gets his voting changes through, it's hard to see him not calling an early, double D election. Why? Because once he's done the micro-party Senators in the eye, it's hard to see him ever getting anything through the present Senate.

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Why economic modelling results are dodgy

Modelling is hugely fashionable in Canberra (joke intended). Any lobby group seeking to persuade the government to do something – or not do something – produces allegedly independent modelling that supposedly backs up their case.

Government isn't above using modelling to make its case, either. Had Malcolm Turnbull decided to go ahead with raising the goods and services tax, he would have produced modelling to show how wonderful that would be.

When he decided not to increase the GST, he naturally produced modelling to show that the gains to the economy would have been minor.

Have you detected my note of scepticism? The mathematical models of the economy that economists produce are supposed to be an aid to thinking. In the public debate, however, they're used as a substitute for thinking.

When it suited the government to make public a version of Treasury's modelling of a "tax mix switch" – raising the GST and using the proceeds to cut income tax – it came with a product warning: "This modelling is indicative at best and care should be taken with its use".

That was inserted to protect the modellers' professional reputation from criticism by people like me.

It's a gross understatement. What it should say is: we've been asked to answer a question our model is incapable of answering with any reliability but, because we enjoy modelling – and are quite well paid to do it – we've fudged up something that looks like an answer.

People are impressed by economic modelling because it's done on a computer. It has to be because it involves solving so many equations and so many calculations.

So, at one level, modelling is highly sophisticated. At another level, however – and this is the bit the punters never get – it's amazingly primitive. Why? Because the economy is so hugely complicated that no simplified model of it is capable of doing justice to its many possible reactions to some development.

Be clear on this. I was pleased when Turnbull decided not to increase the GST. It wouldn't have been a good change. And I happen to agree that a tax mix switch reliant on the GST would do little to increase economic efficiency or foster "growth and jobs".

So I'm not attacking Treasury's modelling for the usual reason people do: because its findings don't accord with their prejudices. No, what I object to is the way economists (who just want to be paid to keep playing with their models) collude with politicians and vested interests in using modelling to hoodwink the public.

Try to con my readers and I'm like the mother bear in The Revenant.

What if I told you that rather than a tax with an $18,200 annual tax-free threshold and rates of tax rising from 21 per cent to 47 per cent as incomes rise, the personal income tax modelled by Treasury was a flat-rate tax of 16.7 per cent, applying from the first dollar of income?

It's true. You can read all about it in a Treasury working paper published last April.

But we've never had such a tax and are never likely to. It's radically different to the progressive tax we do have. So why on earth would you use it for the modelling?

Because it's the best the model can do. It's simply not capable of modelling our real-world income tax. Why not? Because the model has just one household in it - the "representative" household.

But it does have 111 businesses – one for each of the 111 industry sectors it identifies. To this it adds one government (not eight) and one "foreign sector".

The basic model Treasury – and many other modellers – uses is called a "static, representative household, computable general equilibrium (CGE) model".

The CGE bit means the model attempts to cover the whole economy, not just one bit of it. This allows it to capture some of "the main second-round effects of taxes on households, firms and investors". It's also able to capture interactions between different taxes.

But that advantage comes with the huge disadvantage of the single, representative household. We know Australia's 9.2 million households differ greatly in many respects – size, age, income, spending patterns, saving rates, ability and desire to work.

But for "analytical tractability" (to stop the model becoming impossible to understand, even by the modeller) all these dimensions are reduced to averages. And, as we know, the statistical average household, being a mixture of everything, is often quite un-representative.

Apart from being unable to cope with a progressive income tax, the model is also unable to cope with means-tested welfare benefits. It was able to model only a fraction of the compensation that would have had to accompany an increase in the GST (the huge cost of which is the real reason Turnbull abandoned the idea, not the happy modelling about benefits to the economy).

The model assumes that an increase in the rate of tax discourages people from doing as many hours of paid work. But it uses a single, average "elasticity of labour supply" (the degree of workers' responsiveness to changes in their after-tax wage) for the representative household.

Really? Professor Patricia Apps, of Sydney University, points to the empirical evidence showing that "primary" earners (mainly husbands working full time) have quite low elasticity – have you tried telling your boss that from now on you'll be working only 37 hours a week, not 38? – whereas "secondary" earners (mainly mothers working part time) have quite high elasticity.

Averaging the two together makes the exercise meaningless.

The modellers concede that "general equilibrium models are necessarily a simplification of the economy and, as such, they can only incorporate a stylised representation of the tax system".

I'd say models are a cartoon caricature of the economy, quite incapable of answering the intricate questions we ask of them.

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Turnbull is fumbling his bid for greatness

Malcolm Turnbull is slipping. Not just in the opinion polls, that's merely a symptom of his problem. No, he's slipping in his shot at being one of our great prime ministers.

And if he rushes off to a double dissolution election in July because he fears he may not win if he waits until September, that will be a sign his place in the prime ministerial hall of fame will be up the back with his three immediate predecessors.

When Turnbull displaced Tony Abbott five months ago I, like many others, dared to hope his ascension represented a new beginning for Australian politics.

An end to the spiral of ever-declining standards of political behaviour, the negativity, the broken promises, the short-sightedness, the tit-for-tat mentality, the reciprocal scare-mongering, the unceasing attempts to "wedge" the other side, the blatant appeal to our baser instincts.

The eternal emphasis on attaining and retaining power, rather than on using that power to make Australia a better place to live and work.

To be fair, there was no way any flesh-and-blood politician could have lived up to the unrealistic expectations we had for him. And Turnbull does fit the bill in one important respect: he speaks and looks and acts like a prime minister should. He has gravitas.

But the closer we get to the pointy end of the Coalition government's first term, the more possibilities for improvement are being taken off the table to leave the second-term work program awaiting the voters' approval, the more Turnbull seems to be shrinking to the size of his stunted predecessors.

Just in the past week or so we've Scott Morrison doing Joe Hockey impressions, and Turnbull resorting to the same cheap tactics as the man he overthrew.

I'm not prepared to condemn Turnbull for failing to slash and burn government spending at a time when the economy is still not fully back on its feet.

But when you remember all the Coalition's carry-on over the "budget emergency", the insouciance with which Turnbull and Morrison have consigned the budget deficit to the too-hard basket is breathtaking.

I've been happy to defend Turnbull against the unthinking notion that increasing the goods and services tax and channelling the proceeds to foreign investors and people on the top personal tax rate is the be-all-and-end-all of tax reform.

Fail to deliver for big business and you're utterly lacking in courage.

Nonsense. The four tax subsidies to which the tax reform spotlight has turned – superannuation tax concessions, work-related deductions, negative gearing and the concessional taxing of capital gains – carry plenty of potential for changes that make the tax system both a lot fairer and more economically efficient, that is, less distorting of the choices individuals and businesses make.

One of my fears has been that the success of Abbott's unrelentingly destructive attack on the Rudd-Gillard-Rudd government would leave us with a Labor opposition committed to nothing more than getting its own back.

Bad behaviour breeds bad behaviour. Labor has descended to pay-back. Bill Shorten's scare campaign on increasing the GST has been a match for all the dishonest things Abbott said about "debt and deficit" and the way the carbon tax would destroy the economy.

But in one important respect Labor has risen above negativity and created an opening for Turnbull to be greater than his predecessors. It has announced controversial policies to reform super tax concessions, negative gearing and the half taxation of capital gains that is the mainspring of negative gearing.

This has presented Turnbull with an opportunity to make this election a contest of ideas and plans rather than a slanging match. My plan's better than his for the following reasons.

I hope I'm wrong but, as each day passes, it seems clearer that Turnbull isn't preparing to match Labor's boldness with boldness of his own. He'll do something on each of those four tax subsidies, but not much.

Rather, he's reverting to the Abbott tactic of portraying Labor as high-taxing and the Libs as low taxers. (Only a true believer would believe it's that simple.) He's launched into an Abbott-like scare campaign, claiming Labor's negative gearing plan would knock house prices for six.

Turnbull's confidence seems to have faltered. He's looking behind him at his fractious backbench and at the Liberal heartland, who don't want to give up a cent of the tax subsidies that go mainly to them.

That's the behaviour of a survivor. The behaviour of a future great prime minister is to look out at all those uncommitted and even Labor-leaning voters who would vote for him if they thought he really cared about making the tax system fairer; if he still inspired them.

We wouldn't be onto our fifth prime minister in five years if federal politics wasn't dominated by moral pygmies – people lacking in courage, who see tactics but not strategy, whose only vision is of their survival in their seat and their progression up the party pecking order.

What the pygmies don't see is that the public can smell politicians and parties who put their careers ahead of serving the nation. What few people in Canberra remember is that Bob Hawke and Paul Keating achieved greatness by making changes they believed the nation needed, but their own supporters hated.

Turnbull will never be great if he takes his political advice from pygmies.

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Tax reform to bring greater fairness, efficiency

The Abbott-Turnbull government may be doing a good impression of a government going round in circles, but don't let big business and its cheer squad convince you we'll be getting little in the way of tax reform.

We look like getting quite a bit of reform, just not the type of reform the big end of town was hoping for. And this will require quite a bit of courage on Malcolm Turnbull's part.

To be fair, however, much of Turnbull's courage will be coming courtesy of his Labor opponents, who've broken the Abbott mould on short-sighted, destructive politicking.

Big business defines "reform" as cuts to the rate of company tax and the top personal tax rate – that is, rejigging the system in favour of foreign investors and high domestic income-earners. There'll be little of that.

What we do look like getting in the way of reform is greater fairness ("equity") in income tax via the removal or reduction of various "tax expenditures" – or tax subsidies as Labor calls them – used mainly by high income-earners.

Turnbull seems to be planning to use savings from the reform of superannuation tax concessions, work-related deductions, negative gearing and maybe even the concessional taxing of capital gains to pay for a modest round of tax cuts.

All four of those tax subsidies have been crying out for reform for years. The fact that they're yet to be fixed despite various attempts and quick retreats is a sign of how controversial they'll be.

Last year, when Joe Hockey was exploring superannuation reforms and Labor said it would definitely be proposing its own reforms, Tony Abbott immediately swore not to touch super so he could portray Labor as high taxing.

Fortunately, Turnbull isn't so destructive. He's more inclined to regard Labor's policies as providing cover for him to act – or maybe even pinch.

The government's super reform may involve limiting the amount of annual contributions able to be made at the concessional tax rate of 15 per cent. It may also tighten the limits on after-tax contributions.

Many workers exaggerate the size of their work-related deductions, but the real rorting is done by wealthy doctors and lawyers claiming for professional development seminars at that renowned hall of learning, Hawaii.

Last week Labor announced good policies to reform negative gearing and the capital gains tax. It proposes to limit negative gearing to new housing from July 2017, with existing investments unaffected.

It would halve the capital gains tax discount to 25 per cent for assets purchased after the same date, with previous purchases unaffected.

Labor's willingness to propose changes that the well-off won't like will encourage Turnbull to do something in this area, though he's unlikely to be as brave.

It sounds like he's planning to put a limit on the number of homes you're allowed to negatively gear, which would affect only a relative handful of investors.

But removing or reducing those four inequitable tax subsidies is only half the story; the other half being what will be done with the tax savings?

If the government had any guilt over its claims of a "budget emergency" to get itself elected, it would use those savings to reduce the deficit.

Instead, it will cut income tax at a time when that's the last thing the budget can afford. Why? Because it's raised expectations of a tax cut that it dares not disappoint.

It's spent its whole term exaggerating the problem of bracket creep to justify a tax cut. If it stuck to that rationale, people near the bottom of the tax scale would get proportionately bigger tax cuts – measured by the fall in their average tax rate – than people near the top.

But I bet they won't.

While all four reform areas would make the tax system fairer, there would also be economic efficiency benefits.

To tax some forms of investment income more lightly than others distorts behaviour.
We've got an investment tax regime that encourages borrowing over saving, speculation over hard work, and passivity over enterprise. A nation already too in love with bricks and mortar has a distorted tax system that makes it worse.

We have a negative gearing loophole no other country tolerates, which is forcing house prices far higher than they need to be and, in the process, locking much of the younger generation out of home ownership.

Don't try to tell me fixing those allocative​ inefficiencies isn't reform.

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Innovative idea would fix brown coal problem

Tony Abbott's decision to put short-term popularity ahead of the nation's longer-term economic interests by abolishing the carbon tax has left Malcolm Turnbull with more than a few problems. Just one is the likelihood that less-polluting power stations will close while more-polluting ones keep pumping out greenhouse gases.

At the Paris summit late last year, our government was shamed into promising to step up our reduction of carbon dioxide emissions, even though, without the carbon tax, we lack an economic instrument strong enough to bring the promised reduction about.

But we could make some progress if we could find an acceptable way of taking out of production the worst of Victoria's brown coal (lignite) power plants. The emissions per unit from these plants are about 50 per cent higher than for black coal plants.

The problem is explained in a paper by Associate Professor Frank Jotzo, of the Crawford School of Public Policy at the Australian National University, and Salim Mazouz, of EcoPerspectives.

Thanks to our less wasteful use of electricity and the growth in sources of renewable energy, we now have excess capacity to produce coal-fired power. Sooner or later, some power stations will have to close.

Trouble is, the absence of a price on carbon means there's no guarantee it will be the more-polluting brown-coal plants that bite the dust.

That's because brown coal-fired electricity is significantly cheaper to produce than black coal-fired power.

Why? Because the brown coal power stations are right next to the brown coal mines, thus minimising the cost of shipping the coal to the station.

And the brown coal itself is cheaper because there's nothing else to do with the stuff, whereas black coal could be exported to foreign power plants, which would pay well for it. (Black has a higher "opportunity cost".)

The lower cost of brown coal-fired power (lower "short-run marginal cost", in the jargon) means the brown coal stations do well in the continuous auction to sell power into the national electricity grid.

This means that, though the decline in demand for power from the grid has caused the level of production capacity use to fall for all types of power plants, the brown coal plants are still operating at about 70 per cent of capacity, compared with black coal plants at about 50 per cent.

That's more reason to fear that, if the question is left to be resolved by the market, the plants that close won't be the high emitters.

If we had a decent carbon tax – or emissions trading scheme, they're much the same thing – it would add more to the cost of brown power than it would to black power, so to speak, because its impost varies according the emissions-intensity of the product being taxed.

So, provided the tax was sufficiently high, it would push the firms in the market in the direction that was most desirable from the perspective of tackling climate change. Which, of course, is the reason you have a carbon tax.

But although various power stations aren't making adequate profits, there's little sign that any of them is close to throwing in the towel.

Why not? Because each of the potential quitters is telling themselves that, if they can only hang in there longer than a couple of the others, they'll get their cut of the departing firms' market share, meaning they'll then be in better shape.

Such a Mexican standoff is known to economists as a "collective action problem". The firms in a market have got themselves into a situation where they realise that something they're each doing is damaging to themselves and everyone else, but no particular firm is willing to be the first to stop doing the crazy thing because they fear their rivals would take advantage of them.

Many economists give you the impression competition is an unalloyed benefit. Collective action problems are an example of the downside of competition.

Which means they're an instance of "market failure" – circumstances where problems can't be solved simply by leaving it to the market. (Another instance of market failure is, of course, the damage to the climate caused by greenhouse gas emissions.)

The existence of market failure establishes the case for government intervention in the market – provided you can be confident the intervention will make things better rather than worse.

Intervention by the government is pretty much the only solution to collective action problems. The government comes in over the top and imposes a solution equally on all the firms in the market, which go away pleased they no longer feel obliged to do the crazy thing.

Here's the point: Jotzo – an environmental economist of international stature – and his colleague have proposed an ingenious, innovative, agile solution to the brown coal problem, one that would cost the government and the taxpayers nothing.

You invite the four brown coal power producers to enter an auction by nominating the minimum amount they'd need to receive to be willing to close down. You'd pick the winner or winners according to the ones that offered the cheapest cost per unit of emissions reduced.

You'd be hoping the winners were Hazelwood, owned by GDF Suez, the oldest and most emissions-intensive generator, and Yallourn, owned by Energy Australia, the second oldest and second most emissions-intensive generator.

But the government wouldn't just hand over a cheque. Rather, it would recover the cost by imposing a levy on all the remaining black and brown power plants – those that would benefit from the closures – in proportion to their emissions.

It's true the remaining power stations would want to pass that extra cost on to their customers. But because distribution costs (poles and wires) are so great, the (higher) wholesale price is only a small part of the retail price, meaning the effect on households is likely to be small.

Not a bad idea.

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