The real reason the budget may stay in deficit for the next 40 years

If you follow a rule that when a politician cries “look over there!” you make sure you stay looking over here, there’s much to be deduced from Treasurer Josh Frydenberg’s Intergenerational Report, before we put it up on the shelf with its four predecessors.

That’s especially so with a federal election coming by May next year. Elections are times when politicians try to convince us they can do the arithmetically impossible: cut taxes while guaranteeing adequate spending on “essential services” and getting on top of “debt and deficit”.

Intergenerational reports always involve sleight of hand. They’re always about getting us to focus on a certain aspect of the problem and ignore other aspects.

As Frydenberg admits, the five-yearly intergenerational reports “always deliver sobering news. That’s their role. It is up to governments to respond.”

He’s given us little idea of what that response will involve. But there’s little doubt about his sobering news: the budget is projected to stay in deficit in each of the 40 years to 2060-61.

And we’re left in no doubt about the stated cause of those deficits and growing government debt: excessive growth in government spending.

As the report’s authors confess in an unguarded moment, “the emphasis of the [successive intergenerational] reports rested on pressures that demographic change [that is, the ageing of the population] was likely to impose on future government spending”.

We’re told that, even after you remove the effect of inflation, government spending per person is projected to “almost double”. (And I thought only journalists were prone to exaggeration. “Almost double” turns out to be an increase of 73 per cent.)

Why the huge growth in real terms? Mainly because of huge growth in spending on healthcare, but also because of big growth in spending on aged care and interest payments.

Get it? Government spending will grow like steam because of the ageing of the population. Except that when you read the report’s fine print you find that’s not the main reason. Only about half the projected growth in health spending is explained by population growth and ageing.

The other half is explained by advances in medical “technology, changing consumer preferences and rising incomes”. That is, as Australians’ real incomes rise over time, they want to spend a higher proportion of that income on preserving their good health and living longer.

And improved medicines and procedures almost always cost more than those they replace. But voters won’t tolerate government delay in making the latest drugs and operations available under Medicare.

As for the projected greatly increased spending on aged care, only part of it’s due to the Baby Boomers eventually reaching their 80s. The rest is explained by “changing community expectations”.

That’s a bureaucrat’s way of saying that “after the royal commission confirmed all we’ve been told about widespread mistreatment of people in aged care, governments will have no choice but to stop doing aged care on the cheap”. That is, it’s the higher cost of better-quality care.

Expressed as a percentage of national income, spending on the age pension is expected to fall as bigger superannuation payouts put more people on part-pensions. And, even though this saving is projected to be more than offset by the increased cost to revenue of super tax concessions, the combined effect is that the retired will have a lot more money to spend than their parents did.

Now get this: whereas total government spending is projected to grow, in real terms, at an average rate of 2.5 per cent a year in the coming 40 years, this compares with growth of 3.4 per cent a year over the past 40 years.

So it’s not just that ageing doesn’t adequately explain the expected growth in government spending, it’s also that the projected 40 years of budget deficits can’t be adequately explained by excessive spending.

The real reason the spending horse is expected to outrun the taxing horse is that the taxing horse has been nobbled. At a time when the coronacession led to a huge blowout in the budget deficit, the government used this year’s budget to bring forward the second stage of its tax cuts, and will proceed with the third-stage tax cut in July 2024 despite the continuing deficits and rising debt.

Worse, the projections assume that, because projected tax collections would otherwise exceed the government’s self-imposed limit on taxation as a proportion of national income after 2035-36, we’ll be getting new tax cuts in each of the last 15 years up to 2061. Yes, really.

No wonder interest payments are projected to account for three-quarters of the budget deficit in 2060-61.

We can be sure Scott Morrison will go into the election campaign claiming the Liberals are the party of lower taxes. But what voters will have to decide is whether a re-elected Morrison government would “respond” to the Intergenerational Report’s projection of its existing policies by letting taxes grow, slashing spending on “essential services” or letting debt and deficit just keep keeping on.

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Our aspirations for a Big Australia need a big trim

Almost all the nation’s business people, economists and politicians believe too much population growth is never enough. But if there’s one thing I hope to be remembered for, it’s that I always subjected this case of group think to critical examination.

I remain to be convinced that a Big Australia would be better either for our material living standards or for our efforts to limit the damage our economic activity is doing to our natural environment – the erosion of the nation’s “natural capital”.

But, in any case, Treasurer Josh Frydenberg’s intergenerational report last week is a useful warning that our aspirations for a Big Australia need a big trim.

The pandemic is an immediate setback to such ambitions, but beyond that is the likelihood that most countries’ population growth is slowing and, in many countries, will eventually begin falling.

One big message from the report is that population growth over the next 40 years is projected to be much slower than earlier thought, with its size now expected to reach 40 million in the first half of the 2060s, about eight years later than the 2015 report projected.

This is explained by the pandemic, which is expected to cause a temporary fall in the birth rate and four years of below-average net overseas migration (foreigners arriving minus locals leaving). Annual net migration is expected actually to fall in the financial year just ended and in the new financial year, then take two years to return to 235,000 in 2024-25, at which level it then stays every year through to 2060-61.

That is, no catch-up is expected for the growth lost because of the pandemic. The assumed annual net intake of 235,000 is based on unchanged existing federal government policy on permanent and temporary migration levels.

The report’s “sensitivity analysis” shows that, were net migration projected to grow in line with the growing population (at a rate of 0.82 per cent a year) rather than stay at a flat 235,000 a year, real gross domestic product per person would be only a fraction higher in 2060-61, the labour force would be 1 million bigger and the old-age dependency ratio would be 2.8 workers per oldie rather than 2.7.

But you have to doubt whether future governments will remain free to just dial up their preferred level of annual immigration the way they have been over the past 40 years.

If there’s one demographic lesson we should have learnt by now, it’s that as families become more prosperous over the generations, they choose to have fewer children. This has become possible because of effective contraception.

Add growing longevity and you see why a declining fertility rate (expected number of births per woman), not just the retirement of the Baby Boomer bulge, has left all the developed economies with an ageing population. And, thanks to its one-child policy, the world’s most populous economy, China, also has a (rapidly) ageing population.

Like all the other rich countries, our fertility rate has long been below the population replacement rate of 2.1 babies per woman. Unlike most of the others, however, we’ve kept our population growing strongly by ever-increasing immigration.

To date we’ve had no trouble attracting all the skilled (and unskilled) workers we need, mainly from poor countries. We’ve even been able to make a lot of them pay full freight for their Australian-quality education before we scooped them up.

But with population ageing and old-age dependency ratios becoming more acute around the rich world, global competition to attract skilled workers from developing countries may become more intense.

On the other side of the equation, the supply side, as the poor countries become more developed, their living standards rise and their fertility rates fall, there may be fewer skilled workers willing to emigrate to the rich countries.

Population growth is already slowing in most developed and developing countries. It’s already falling in Japan and some European countries. It will start falling in China this decade. Our population growth is also likely to slow, and the day may come when – horror of horrors – it starts to fall.

Slower growth in the population means slower growth in the size of the economy, of course. But I can’t see why this should be a worry.

It’s notable that, though the intergenerational report projects a consequent slowing in economic growth over the next 40 years, it expects this to have little effect on economic growth per person and thus on living standards.

Whereas real GDP growth is projected to slow from 3 per cent a year over the past 40 years to 2.6 per cent over the coming 40, annual growth in real GDP per person is projected to slow only marginally from 1.6 per cent to 1.5 per cent.

Even that small slowing seems to be explained not by lower population growth, but by a similar fall in the assumed rate of average annual productivity improvement.

Taken at face value, this is an admission by the report’s authors that faster population growth makes little or no contribution to the improvement of our material living standards. The immigrants may gain by moving to Australia, but the rest of us don’t gain from their coming.

However, the report’s fine print (aka its technical appendix) advises that its projections “do not capture the broader economic, social or environmental effects of migration, such as technology spillovers or congestion”.

But if those effects were thought to be significant, you’d expect the authors to have made the effort to model them. And, of course, the effects are likely to be both beneficial and detrimental.

Looking at the economic effects, the advocates of high immigration always point to the benefit of greater economies of scale, while brushing aside the costs of the increased housing, capital equipment and public infrastructure that a bigger population and workforce must be provided with to ensure the productivity of its labour doesn’t fall.

Indeed, it’s possible our high rate of population growth is a factor contributing to our weak rate of productivity improvement.

Similarly, it’s inconsistent for advocates of high immigration also to be advocates of Smaller Government. When you’re causing congestion by failing to spend enough on the extra public infrastructure needed, including more schools and hospitals – perhaps because you’re trying to please discredited American credit-rating agencies – you shouldn’t be surprised if economic growth is weaker.

The need for governments to spend more on a bigger population is complicated and compounded by the division of responsibilities between federal and state governments. The budgetary costs and benefits of immigration are not spread evenly between federal and state governments.

The feds pick up most of the tax that immigrants pay, while the states pick up most of the cost of the extra infrastructure and services needing to be provided (especially since immigrants are denied access to many federal benefits for the first four years).

This reveals a major distortion in the intergenerational report’s continual claim that higher immigration does wonders to improve the budget. The federal budget, yes. But state budgets, probably the reverse.

Finally, there are the environmental consequences of a bigger population that both the intergenerational report and most business people, economists and politicians refuse to come to grips with.

Jenny Goldie, president of Sustainable Population Australia, reminds us that the intergenerational report “fails to take into account the environmental costs of urban encroachment on natural bushland, threatening iconic species such as the koala [and biodiversity more generally], and adding to carbon emissions.

“It fails to address the social costs of crowding, housing unaffordability and longer waiting times that generally accompany population growth,” she concludes.

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Business lobbies use the productivity slump for rent-seeking

It’s encouraging to see the scepticism with which this week’s intergenerational report from Treasurer Josh Frydenberg has been greeted. Any attempt to peer 40 years into the economy’s future will prove close to the mark only by happy accident.

But it’s discouraging to see the way the usual suspects have seized on the report’s most glaring weakness to do no more than push their vested interests in the name of “reform”.

This fifth version of the five-yearly intergenerational report allows us to see how far astray the report’s earlier projections have been, even though we’re only halfway towards the first report’s picture of the economy in 2041.

In their projections of growth in the population, its authors have repeatedly overestimated the fertility rate (expected number of births per woman) and underestimated the growth in net overseas migration (foreigners arriving minus locals leaving).

They predicted that the retirement of the Baby Boomers would see a fall in the rate at which people of working age participate in the labour force, but this “participation rate” has recently been at record highs.

It would be nice to think that, since the object of all these projections has been to alert us to looming pressures on the budget – caused, in particular, by the ageing of the population – governments have responded accordingly, thus making the reports’ prophecies self-defeating. Nice, but not likely.

The pandemic, and the expected four years of weak net overseas migration in particular, is rightly blamed for our population “growing slower and ageing faster” than previously expected. And slower growth in the size of the population means slower growth in the size of the economy.

We’re told that, whereas real GDP grew at the average rate of 3 per cent a year over the past 40 years, it’s now projected to slow to an average rate of 2.6 per cent over the coming 40.

But the justification for our obsession with economic growth is our desire for faster improvement in our material standard of living. And here’s a point Frydenberg hasn’t highlighted: according to the report’s calculations, the projected marked slowing in the economy’s overall rate of growth is expected to affect growth in GDP per person – a crude measure of living standards - only a little.

GDP per person’s average annual growth is projected to fall only from 1.6 per cent over the past 40 years to 1.5 per cent over the coming 40.

It’s here, however, that business and its media cheer squad have read the fine print and are deeply sceptical: that projection of GDP growth per person rests heavily on the mere assumption that the productivity of labour (output of goods and services per hour worked) will improve at the same average annual rate in the coming 40 years as it did over the past 30 years.

And they’re right. Of all the many assumptions on which the report’s mechanical projections depend, this assumption is far the most critical. As Frydenberg rightly says, improving productivity is what explains almost all the improvement in our standard of living over the decades.

And the sceptics are right to doubt that productivity will improve over the next 40 years at anything like the rate of 1.5 per cent a year. For a start, that 30-year average includes the 1990s, a decade when productivity improved at a rate far higher than experienced before or since.

For another thing, productivity improvement in recent years has been much weaker than usual.

So, purely by omission, the latest intergenerational report reminds us of the second biggest threat to our living standards: a continuing slump in productivity. (The biggest threat is the world’s inadequate response to climate change – another thing the report omits to take into account.)

What’s discouraging, however, is the way the business lobby groups have used this inadvertent reminder to bang the same old self-serving drum. The productivity slump has been caused by this government and its predecessors’ failure to continue the economic reform program begun by Hawke, Keating and Howard, we’re assured.

And what reforms do they have in mind? A cut in the rate of company tax for big business and changes in the wage-fixing rules to make the labour market more flexible for employers.

This lobbying is objectionable on three grounds. First, it implies that productivity improvement depends on an unending stream of changes in government policies, which is absurd. The day “reform” stops, productivity stops.

Second, it shifts the blame for weak productivity improvement from the actions of the private sector – in whose farms, mines, factories, offices and shops productivity either gets better or worse – to the politicians in Canberra.

Third, it seeks to disguise blatant rent-seeking as economic “reform”. Productivity would improve if business owners and high income-earners paid less tax, leaving the punters to pay more, and if the balance of bargaining power between bosses and workers shifted further in favour of bosses.

What this self-serving bulldust ignores is that productivity improvement has slumped in all the rich countries, not just in Australia because our pollies are so defective.

Michael Brennan, chair of the Productivity Commission, says the world’s economists are still debating the causes of the productivity slowdown.

They’ve pointed to “mismeasurement issues, a shift towards lower productivity industries, population ageing, a slowdown in the pace of technological discovery, a slowdown in the pace of technological diffusion, a plateauing of improvements in human capital, reduced rates of firm entry and exit, increased concentration and market power, lower capital investment, a shift to intangible capital and the slowing growth in global trade”.

As Melinda Cilento of CEDA, the Committee for Economic Development of Australia, has noted, “research by federal Treasury . . . showed leading Australian firms were not keeping up with leading global firms on productivity”.

Treasury would be much better employed continuing to research the causes of our productivity slump than doing literally unbelievable projections of what’s unlikely to happen over the next 40 years.

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Sorry, I'm too old to believe an ageing population is a terrible thing

If ever there was an exercise that, since its inception, has overpromised and under-delivered, it’s the alleged Intergenerational Report. A report on relations between the generations, on the legacy the present generation is leaving for the coming generation?

No, not really. If it was, it would be mainly about the need for us and the other rich countries to be acting a lot more seriously and urgently to limit climate change. The document Treasurer Josh Frydenberg unveiled on Monday is our fifth five-yearly Intergenerational Report.

Initially, the report made no mention of climate change. These days, following the obvious criticism, it always includes a brief chapter on the topic, before moving on to matters considered more pertinent.

This year the chapter runs to nine of the report’s almost 200 pages, in which the seriousness of the problem is acknowledged, along with the assurance “but don’t worry, I’m on it”. On every admitted dimension of the issue, we’re assured that reports have been commissioned, committees established and the government is spending $100 million on this and $67 million on that.

Another issue of relevance to relations between the generations is the ever-declining rate of home ownership as the price of houses rises ever higher. Can the aggrandisement of one generation at the expense of following generations continue? And are we content to witness the trashing of the Great Australian Dream? I found no discussion of this.

The sad truth is the Intergenerational Report is a creation of the Charter of Budget Honesty Act so, despite its grandiose name, it’s really only interested in the future state of the federal budget and in attempting to predict the size of the budget balance in 40 years’ time.

According to Frydenberg, the latest report delivers “three key insights”. First, our population is growing slower and ageing faster than expected. Second, the economy’s growth will be slower than previously thought. Third, while the federal government’s debt is sustainable and low by international standards, the ageing of our population will put significant pressures on both government revenue and its spending.

Get it? The real concern of this report – and its four predecessors – is what the ageing of the population looks likely to do to the federal budget over the next four decades. It thus echoes a longstanding concern of all the rich countries that the retirement of the Baby Boomers will put huge pressure on their budgets.

When you read the document minus the spin successive treasurers always put on it, this year’s version tells us what all five reports have told us: compared with the Europeans and Americans, we don’t have much of a problem.

The report’s big news is that our decision to close our borders as part of our response to the pandemic means our annual level of net immigration – foreigners arriving minus locals leaving – isn’t expected to return to normal until 2024-25.

According to Frydenberg, this is the first report “where the size of the population has been revised down”. But this is misleading. It doesn’t mean our population will fall, only that it won’t keep growing as fast as it has been and was expected to continue doing.

We’re now expected to have four years of below-normal net immigration, with no subsequent catch up. So whereas the previous report projected that the population would reach almost 40 million by 2055, it’s now expected to be no more than 39 million in 2061.

Since almost all the nation’s business people, economists and politicians believe too much population growth is never enough, this news will worry them. It doesn’t worry me. And I suspect most Australians will regard it as good news, not bad.

Frydenberg argues it’s bad because, since immigrants tend to be younger than the average Aussie, it will cause the population to age faster than was expected. This is arithmetically correct, but Frydenberg has given us an exaggerated impression of its extent.

He tells us that, in 1982, there were 6.6 people of traditional working age for every person over 65. Today, the ratio is down to 4.1, and by 2061 it will have fallen to 2.7. Wow. And what did the previous report tell us it would be down to by 2055? 2.7. Oh, no significant change.

Even so, isn’t that a worry? Not when you remember what economics teaches: that the economy adjusts in response to changing circumstances.

As Jenny Goldie, president of Sustainable Population Australia, has explained to the Treasurer, “as the working-age population shrinks and the labour market tightens, fewer people will be unemployed, and employers will improve wages and salaries to attract job seekers.

“This will have the effect of drawing more people into the workforce who were not working, or keeping people who would otherwise have retired.” Employers will no longer be able to afford their prejudice against hiring older workers.

If your instincts tell you not to believe those trying to convince you that people now living longer than they used to is a real worry, your instincts are right.

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Slowly, economists are revealing the weaknesses in their theories

Economics is changing. It’s relying less on theorising about how the economy works, and more on testing to see whether there’s hard empirical (observable) evidence to support those theories.

Advances in digitisation and the information revolution have made much more statistical information about aspects of economic activity available, and made it easier to analyse these new “data sets” using improved statistical tests of, for instance, whether the correlation between A and B is causal – whether A is causing B, or B is causing A, or whether they’re both being caused by C.

But another development in recent decades is economists losing their reluctance to test the validity of their theories by performing experiments. Let me tell you about two new examples of empirical research by Australian academic economists, one involving data analysis and the other a laboratory experiment.

We see a lot of calls for reform that take the form: change taxes or labour laws in a way that just happens to benefit me directly, and this will make “jobs and growth” so much better for everyone.

These reformers always convey the impression that the changes they want are backed by long established, self-evident economic principles. And they can usually find professional economists willing to say “yes, that’s right”.

But what gets me is that, when the self-declared reformers get their “reform”, it’s rare for anyone to bother going back to check whether it really did do wonders for jobs and growth. Wouldn’t there be something to learn if it was a great success, or if it wasn’t?

Do you remember back in 2017, when employers were campaigning for a reduction in weekend penalty rates? The retailers and the hospitality industry told the Fair Work Commission that making them pay much higher wage rates on Saturday and Sunday was discouraging some businesses from opening on weekends, to the detriment of the public’s convenience.

If only penalty rates were lower, more businesses would open on weekends, or stay open for longer, meaning consumers would spend more, and more workers would be employed for more hours, leaving everyone better off.

The employers got strong support from the Productivity Commission and some economist expert witnesses. So the commission decided to reduce the Sunday and public holiday penalty rates in the relevant awards by 25 to 50 percentage points, phased in over three years.

Associate Professor Martin O’Brien, of the University of Wollongong’s Sydney Business School, commissioned a longitudinal survey (looking at the same people over time) of about 1830 employees and about 240 owner-managers or employers, dividing the workers between those on awards and a control group of those on enterprise agreements (and so not directly affected).

The economists’ standard, “neo-classical” model of the way demand and supply interact to determine the market price, with movements in the price feeding back to influence the quantity that buyers demand and the quantity sellers want to supply, does predict that a fall in the price of Sunday labour will lead employers to demand more of it.

So what did the survey find? It could find no effect on employment in the retail and hospitality sectors. This is consistent with a growing body of mainly American empirical evidence that, contrary to neo-classical theory, increases in minimum wages have little effect on employment.

But here’s an interesting twist: a majority of employers reported not making the reduction in penalty rates and a majority of employees reported not receiving any reduction.

One explanation for this is that employers didn’t pass on the cuts because they valued staff loyalty and commitment. If so, this fits with the judgment of many labour economists that the relationship between a firm and its workers is far more nuanced than can be captured by the neo-classical assumption that price is the only motivator.

An alternative explanation, however, is that those employers didn’t cut the Sunday penalty rate because they weren’t paying it in the first place.

Turning to the laboratory experiment, it tests the much more theoretical assumption that the behaviour of people engaged in economic activities is guided by their “rational expectations” about what will happen in the future.

Economists have come to care about what people expect to happen because this affects the way people behave, and so affects the future we get. In recent decades, many mathematical models of the macro economy have used the assumption that people form their beliefs about the future in a “rational” way to make the maths more rigorous.

By “rational” they mean that people respond to new information by immediately and fully adjusting their expectations – beliefs – about what will happen to prices, the economy’s growth or whatever. Which is a lovely idea, but how realistic is it?

Dr Timo Henckel, of the Research School of Economics at the Australian National University, Dr Gordon Menzies, of the University of Technology Sydney, and Professor Daniel Zizzo, of the University of Queensland, analysed the results of an experiment conducted by Professor Peter Moffatt, of the University of East Anglia, involving 245 students answering questions.

On receiving each piece of new information, the subjects had first to decide whether to adjust their beliefs and then, if so, by how much. The experimenters found that the subjects reacted very differently.

They found that, in general, people don’t update their beliefs with each new piece of information. And when they do, they tend not to adjust their beliefs by as much as they probably should. In other words, people display a kind of belief conservatism, holding on to a belief for longer than they should.

They found that this conservatism is explained to some extent by people’s inattention – they were distracted by other issues – and to some extent by the complexity of the issue: it was “cognitively taxing”.

It turns out that very few people – just 3 per cent of the subjects – display the rational expectations economists assume in their model-building. Most people’s behaviour, the authors say, is better described as “inferential expectations”.

Now, you may not be wildly surprised by these findings. But, in the academic world, common sense doesn’t get you far. You must be able to demonstrate things the academic way.

Even so, Henckel says that the responses of the experiment’s subjects extend to many parts of life, from the behaviour of investors in the share and other financial markets – this is how bubbles develop – to people’s political convictions, where they hold on to beliefs for far too long, ignoring much contrary evidence.

Indeed, inferential expectations apply even to scientists, who form a view of the world which they will revise or overturn only if there is overwhelming evidence to the contrary. So don’t expect economic modellers to abandon their convenient assumption of rational expectations any time soon.

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Why people can be much nicer than economists assume

There’s a lot you can learn about the world of work – and human nature in general – from studying economics. Then again, there’s a lot you can’t learn from conventional economics – and, indeed, from the bum steers it can give you.

Consider this. The 18th century Scottish philosopher Adam Smith is said to be the father of economics. He wrote two monumental books, the second of which, The Wealth of Nations, contained the famous observation that “it is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own self-interest”.

The worthies who developed conventional economics – and its “neo-classical” model of how markets work, the main thing taught in economics courses – seized on this idea to describe an economy populated by profit-maximising firms and self-interested consumers, all of them competing with each other to get the best deal.

They developed Smith’s reference to the “invisible hand” of competition in markets to show how this self-interest on all sides miraculously ends up satisfying everyone’s wants. Hence modern economists’ eternal banging on about the benefits of competition.

But Smith’s first book, The Theory of Moral Sentiments, said something quite different: “How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of others, and render their happiness necessary to him, thought he derives nothing from it, except the pleasure of seeing it”.

So what’s it to be? Are we totally self-interested, or do we care about the wellbeing of others? Are we individuals competing against each other for the biggest bit, or are we caring souls who co-operate with others to ensure everyone gets looked after?

Short answer: we’re both. But study conventional economics and you’re told only about the selfish, individualistic, competitive side of our nature. The moral, collective, co-operative side is assumed away. Government is seen not as a force for good, but as an alien force whose intervention in the market risks stuffing things up.

If you wonder why so many of the predictions economists make prove astray, that’s part of the reason. But some years back, two American economists associated with the Santa Fe Institute in New Mexico, Samuel Bowles and Herbert Gintis, wrote A Cooperative Species, to try to balance the story.

In the process, they provide a more convincing explanation of why humans have become the dominant species on Earth – for good and ill.

They focus on the way humans co-operate with each other in many circumstances – including when hundreds of us work for a single business, which competes with other big businesses - and argue that we co-operate not only for self-interested reasons, but also because we are genuinely concerned about the wellbeing of others.

We try to uphold “social norms” of acceptable behaviour, and value behaving ethically for its own sake. For the same reasons, we punish those who exploit the co-operative behaviour of others.

“Contributing to the success of a joint project for the benefit of [your] group, even at a personal cost, evokes feelings of satisfaction, pride, even elation,” they say. “Failing to do so is often a source of shame or guilt.”

We came to have these “moral sentiments,” in Smith’s words, because our ancestors lived in environments, both natural and as constructed by humans, in which groups of individuals who were predisposed to co-operate and uphold ethical norms tended to survive and expand relative to other groups, thereby allowing these “pro-social” motivations to proliferate.

So they explain our motivations for caring about the wellbeing of others: we do it because it makes us feel good. But they also explain the distant evolutionary origins of our disposition to co-operate and its perpetuation to the present day.

Co-operation – engaging with others in a mutually beneficial activity - was part of the behaviour of homo sapiens when we were still living on the African savannah. We formed bands to make us more successful in hunting big animals.

But though co-operation is common in many species, human co-operation is exceptional in that it extends beyond our close relatives – whom we look after in obedience to our evolutionary urge to replicate our species – to include even total strangers. And we co-operate on a much larger scale than other species except the social insects, such as ants and bees.

We co-operate in political and military objectives as well as more prosaic everyday activities: collaboration among the employees in a firm, exchanges between buyers and sellers, and the maintenance of local amenities among neighbours.

So, though they don’t see it in these terms, economists focus on a form of co-operation that involves “reciprocal altruism”. Buyers benefit sellers; sellers benefit buyers.

But human co-operation goes much further, in that it takes place in much larger groups and in circumstances that are unlikely to be repeated. Why do people tip while passing through a country town? In my own town I have reason to care about my reputation. But if I’m in your town, why does it not occur to me to cheat you in some way?

Much experimental and other evidence shows that people gain pleasure from co-operating, or feel morally obliged to. On the other hand, people enjoy punishing those who exploit the co-operation of others, or feel morally obligated to do so.

“Free-riders,” as economists call them, frequently feel guilty and, if they are sanctioned by others, they may feel ashamed.

We may have started out co-operating to hunt wild animals and mind other people’s children, but today we co-operate to enjoy the benefits of “the division of labour” (we each specialise in something we’re good at), of market exchange and the pursuit of economies of scale (in irrigation, factories, information networks) and even warfare.

And we made all this work better by inventing governments capable of enforcing the rights to property and providing incentives for the self-interested to contribute to common projects.

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THE GLOBAL ECONOMY

Aurora College Economics HSC Study Day, Sydney

Every year there’s some event in the news that’s relevant to your study of the global economy, and this year’s is the continuation of the biggest ever: the pandemic entering its second year. A pandemic is a global event by definition, and this pandemic has had big implications for global economic growth and for the future of the globalisation push. There’s nothing new about epidemics starting in one country then spreading to many other countries. It’s been happening for millennia. Even so, it’s the world’s worst pandemic since the “Spanish” flu epidemic immediately after World War I, and the first where the greater economic integration of the world’s countries – and particularly, the huge number of people at any time flying around the world on jumbo jets – caused the virus to reach all corners of the world in a few weeks rather than years. We’ll discuss aspects of the pandemic before discussing a problem special to our economy: the trade sanctions imposed on us by China.

The pandemic

Most governments have responded to the pandemic by restricting people’s ability to cross their international borders, and our government has imposed more comprehensive restrictions than most, greatly disrupting our airlines, inbound tourism industry and universities’ export earnings from overseas students. Like other governments, ours acted to limit the spread of the virus by locking down much of the economy for some time. This caused the world economy to plunge into a deep recession, which governments sought counter by applying considerable fiscal stimulus. We have been more successful than most at suppressing the virus and so were soon able to lift the lockdown. So, although our coronacession was the deepest recession since World War II, it was also the shortest, with the economy taking only about three quarters to rebound to where it was before virus arrived. The recovery will be much slower in most other countries. In Australia, the main issue is how long it will take to vaccinate enough of our population so we can safely re-open our borders.

The end of hyperglobalisation

The pandemic has greatly disrupted international trade and thus confirmed that the period of “hyperglobalisation” has ended. One measure of the extent of globalisation is the growth in two-way trade between countries (exports plus imports) as a proportion of gross world product (world GDP). Between 1990 and 2008, global trade rose from 39 pc to 61 pc of GWP – the period of rapid globalisation. But the proportion fell after the global financial crisis, and even by 2019 had not regained its peak in 2008. The absolute level of world trade is expected to have fallen 9 pc in 2020.

It’s worth noting that the poor countries did well out of the quarter-century of rapid globalisation. Between 1995 and 2019, real GDP per person in the emerging economies more than doubled, whereas in the advanced economies it grew by only 44 pc (after allowing for differences in purchasing power).

The temptation of returning to protectionism

Much of the strong global economic growth during the period of hyperglobalisation can be attributed to increased trade in goods and services between the developed and developing countries. But it’s likely that, in the period of slower growth that has followed the global financial crisis, some countries have yielded to the temptation to return to protecting their domestic industries against foreign competition, returning to the (failed) strategy of growth through “import replacement” rather than “export-led” growth. Regrettably, this trend is being led by the two biggest developing economies, China and India.

The Economist magazine reports that during the pandemic, countries have passed more than 140 special trade restrictions. Some of these may arise from concerns in the rich countries over the lack of availability of personal protective equipment, or vaccines. Worries about the pandemic’s disruption of global supply chains may be another reason for the return of protectionist attitudes in the advanced economies.

 China’s trade sanctions against Australia

Australia’s deteriorating relations with China – which could have been handled much more skilfully by our own government – have led it to impose a succession of sanctions, including very high tariffs and non-tariff barriers, against our exports of barley, beef, coal, copper, cotton, seafood, sugar, timber and wine. Together, these exports were worth about $25 billion in 2019, or 1.3 pc of our GDP.

This is an unfortunate development. Our government will challenge the legality of some of these measures at the World Trade Organisation. But two points are worth noting. First, any loss of export earnings from China caused by these sanctions has been far more than offset by the exceptionally high prices China is paying for our exports of iron ore. Second, estimates by the Lowe Institute suggest that our exporters of most of those sanctioned products have been able to find other overseas markets for them.

Definition

The OECD defines globalisation as “the economic integration of different countries through growing freedom of movement across national borders of goods, services, capital, ideas and people”.

That’s a good definition, but I like my own: globalisation is the process by which the natural and government-created barriers between national economies are being broken down.

A process

With this definition I’m trying to make a few points. The first is that globalisation is a process, not a set state of being. Because it’s a process, it can go forward – the world can become more globalised – or it can go backwards, as national governments, under pressure from their electorates, seek to stop or even reverse the process of economic integration. This is just what Donald Trump promised to do in the US presidential election in 2016.

Among the advocates of globalisation there has tended to be an assumption that the process of ever greater integration is inevitable and inexorable. That was always a mistaken notion, but this has become more obvious since Brexit and the amazing exploits of Trump. First, the British have voted to reduce their degree of economic integration with the rest of Europe – a decision most outsiders see as involving a significant economic cost to the Brits’ economy. Second, the Trump Administration has withdrawn from the Trans Pacific Partnership, an agreement between the US and 11 other selected countries (including Australia) to reduce barriers to trade between them – although the remaining 11 have finalised the agreement without the US.  Third, the Trump Administration has withdrawn from the Paris global agreement on reducing greenhouse gas emissions. Fourth, Trump has launched a trade war with China. President Biden will re-join the Paris agreement and repair America’s relations with its allies, but continue the contest with China.

Earlier globalisation

The point is that the process of globalisation is and always was reversible. People should know this because this isn’t the first time the process of globalisation has occurred and then been rolled back. The decades leading up to World War I saw reduced barriers and greatly increased flows of goods, funds and people between the old world of Europe and the new world of America, Australia and other countries. But this integration was brought to a halt in 1914 by the onset of a world war. And the period of beggar-thy-neighbour increases in trade protection, to which countries resorted in response to the Great Depression of the early 1930s, greatly increased the barriers between national economies. Indeed, you can see that, in the years after World War II, the many rounds of multilateral tariff reductions brought about under the GATT – the General Agreement on Tariffs and Trade, which has since turned into the World Trade Organisation – were intended to dismantle all the barriers to trade built up in the period between the wars.

The channels of globalisation

The four main economic channels through which the world’s economies have become more integrated are:

1) Trade in goods and services

2) Finance and investment

3) Labour

4) Information, news and ideas.

Trade is probably the channel that gets most attention from the public. Donald Trump’s populist campaigning against globalisation has focus on the belief that America’s greater openness to trade – particularly with developing countries – has caused it to lose many jobs, particularly in manufacturing, as cheaper imports caused many domestic producers to lose sales, or as factories have been moved offshore to countries where wages are lower, without America receiving anything much in return. These sentiments would be shared by many voters for One Nation.

Surprisingly, financial globalisation didn’t get as much blame as it could have for the global financial crisis and the Great Recession it precipitated. But it’s easier for Australians to remember that the global crisis of 2008 was preceded by the Asian financial crisis of 1997-98, indicating that our highly integrated global financial markets are prone to crises – crises which invariably spill over from the “financial economy” of borrowing and lending, saving and investing, to the “real economy” of producing and consuming goods and services. The push by the G20 to strengthen the capital and liquidity requirement imposed on the world’s banks, though the Basel agreements, is intended to make financial markets more stable.

Most countries have not liberalised the flow of labour into their economy in the way they have the other factors of production. Although increasing numbers of people are fleeing their country to escape war, famine and persecution, many choose the country they’d like to arrive at on economic grounds. Many voters object to the inflow of immigrants, whether they be boat people arriving in Australia, Mexicans crossing the border to the US, or Poles taking advantage of the European Union’s single market to look for jobs in Britain. Immigration seems to have been a major motive for some Brits voting in favour of Brexit.

Income distribution and the gains from trade

One of economists’ core beliefs is that there are mutual gains from trade. Provided the exchange of goods is voluntary, each side participates only because it sees some advantage for itself. This is undoubtedly true, but in the era of renewed globalisation we’ve been reminded that, though the gains may be mutual, they are not necessarily equal. Some countries do better than others.

Similarly, the benefits to a particular country from its trade aren’t necessarily equally distributed between the people within that country. When, for example, a country imports more of its manufactured goods because they are cheaper than its locally made goods, all the consumers who buy those goods are better off (including all the working people), but many workers in the domestic manufacturing industry may lose their jobs.

Another factor that has been working in the same direction is digitisation and other technological change which, in its effect on employers’ demand for labour, seems to be “skill-biased” – that is, it tends to increase the value of highly skilled labour, while reducing the value of less-skilled labour. It seems likely that, between them, trade and technological advance have worked to shift the distribution of income in America, Britain and, to a lesser extent, Australia, in favour of high-income families and against many middle and lower-income families.

The unwelcome surprise many politicians and economists have received from the high protest votes for Brexit, Trump and One Nation is causing them to wonder if too little has been done to assist the workers and regions adversely affected to retrain and relocate, and too little to ensure the winners from structural change bear most of the cost of this assistance.

Shares of the World Economy, 2018

GWP Exports Population

China          19   11     19

United States   15   10         4

Euro area (19 countries)   11   26         5

India     8     2       18

Japan     4     4         2

Advanced economies (39) 41   63       14

Developing economies (155) 59   37       86

            100 100     100

Source: IMF WEO statistical appendix; GWP based on purchasing power parity   

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My new hero, Mathias Cormann, now valiant for truth

I find it hugely encouraging. Don’t know if you’ve heard the glad tidings but, on his road to Damascus – or, in this case, Paris – our own Mathias Cormann, former senator and minister for finance, has experienced a miraculous conversion. He’s gone from persecutor of those who care about climate change to being a leader of the cause.

As we said in my Salvo youth, there is much joy in heaven over one sinner that repenteth. I bet Brother Scott’s joy is unconfined.

And it’s clear from Cormann’s first speech as Secretary-General of the revered Organisation for Economic Co-operation and Development that he’s seen the light on a lot more than climate change. Indeed, the new man is exhibiting a distinct air of wokefulness. He’s now valiant for “stronger, cleaner, fairer economic growth”.

Speaking to a meeting of the OECD’s 37 rich and wannabe-rich member-country Council at Ministerial Level last week, Cormann said: “We need to continue to overcome the immediate health challenge, including by pursuing an all-out effort to reach the entire world population with vaccines.

“This is not just an act of benevolence from advanced economies. It is about sustained virus protection for all of us and about giving ourselves the best chance of a sustained recovery.”

Enlightened self-interest. I love it.

Cormann hasn’t changed his tune on chasing down slippery multinational tax avoiders. “It is very important we [the OECD] continue to lead the global fight against tax evasion and multinational tax avoidance and to ensure that digital businesses and all large businesses pay their fair share,” he said.

“We need to complete this work, including by facilitating agreement on an appropriate minimum level of global taxation and by minimising the profit-shifting that has accompanied the digitisation of our globalised economy.” All well and good.

On other matters, where I come from, there was nothing we enjoyed more than hearing some reformed Trophy of Grace testifying to his former wicked ways. As finance minister, Cormann led the Coalition’s repeated cuts to our overseas aid budget which, as a poor country with a big debt, we were told, we could no longer afford.

The reborn Cormann sees it differently. “We [the rich OECD countries] must also continue to strengthen our development co-operation. Low-income countries need our co-operation more than ever – to ensure access to vaccinations, to trade, to financing to help them deal with the climate challenge,” he said.

Cormann, you recall, was one of Tony Abbott’s lieutenants in abolishing Labor’s (already watered-down) minerals resource rent tax and its “price on carbon”.

At the time we were led to believe Julia Gillard’s carbon tax was the reason the retail price of electricity had risen so steeply. Turned out it was just a small part of the story. Prices stayed high.

But, in any case, new insight has come to Cormann in a blinding flash. “Market-based economic principles work,” he now sees. “Global competition at its best is a powerful engine for progress, innovation and an improvement in living standards.”

True, he admits, competition can be uncomfortable. “It can lead to social disruption which, collectively, we need to better manage.” Love that new thought that we ought to do more things “collectively”. Doesn’t quite roll off Cormann’s tongue, but he’s getting there.

“We need to ensure access to high quality education, upskilling and reskilling to ensure everyone can participate and benefit. We need the necessary social supports for those who struggle,” he said.

Amen to that. No hanging the unis out to dry during the pandemic. No spending a decade starving technical education of funds.

On climate change, he tells us that “more and more countries are committing to net-zero emissions as soon as possible and by no later than 2050.

“The challenge is how to turn those commitments into outcomes and to achieve our objective in a ... way that will not leave people behind.”

It’s easy to be cynical. In my youth, working in a big private-sector bureaucracy and watching people fighting their way to the top, I formed the view that many people were happy to adjust their views to fit their new role in the organisation.

When, with much assistance from the Morrison government, Cormann was travelling the world canvassing support for the top OECD job, many environmental groups were loudly opposing his candidacy. They failed to anticipate the fluidity of his views.

In my limited contact with the man, I found this Rocksolid Roarer of the Right friendly to the point of charming. Remembering how successful he was at getting crossbench Senate support for the government’s controversial measures – and at so little cost to the exchequer – I think he has just the right qualities to succeed in bringing the OECD’s divers members to agreement.

And, after all, he wouldn’t be the first person lately to realise that the climate worm has turned and fossil fuel’s days are ending.

Benediction from the Apostle Mathias: “Protecting ourselves from competition and innovation does not stop it from happening elsewhere – it just means that, over time, those who find themselves behind those protective walls fall further and further behind.”

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