Infrastructure spending has degenerated into wasteful vote buying

The capacity of our politicians to take a good economic policy idea and pervert it into a partisan waste of taxpayers’ money never ceases to appal.

Once I was a big supporter of greater spending on infrastructure projects, even when most of the cost had to be borrowed. That’s because well-chosen projects will add to the economy’s productivity – say, by reducing the time taken to get from A to B – and thus more than pay for themselves over time.

But for that, you have to be sure to pick only those projects that offer economic and social benefits well exceeding their costs. When a politician doesn’t bother with that, but picks projects just on winning votes, you can’t even be sure people in the chosen electorate will gain much benefit.

In this election campaign, the Morrison government’s promise to add transport infrastructure spending of $18 billion to our already high public debt in the hope of buying votes in key electorates, would not only involve wasting much money. It would also “crowd out” spending on more valuable things, such as education, aged care or research.

Of course, Labor plays the same game. In this election, however, it’s proposing to waste no more than $5 billion. (This is a big improvement on the 2019 election, when Labor wanted to spend $49 billion, against the Coalition’s $42 billion.)

It would be good to have some knowledgeable person keeping tabs on these huge sums. And fortunately, there is: Marion Terrill, of the Grattan Institute.

In her assessment of the two parties’ promises this time, she notes that the emphasis on winning votes in key marginal seats is quite unfair. Those of us not in marginal seats get little of the moolah. And some states get a lot more than others. The Coalition is offering nearly $900 per Queenslander, compared with about $500 a person in NSW and Victoria.

As for Labor, it’s offering close to $400 a person in Victoria, with Queenslanders next on about $200 each.

Total bribes are well down this time because billion-dollar projects are less prevalent, with the Coalition offering just five (in ascending cost, the Sydney-Newcastle rail upgrade, the Brisbane-Gold Coast rail upgrade, the Beveridge intermodal terminal in Victoria, the Beerwah-Maroochydore rail extension and the North-South Corridor in South Australia) and Labor offering just one (the Melbourne suburban rail loop).

Note, however, that none of these six projects has been assessed by Infrastructure Australia as nationally significant and worth building. Only one of them has actually failed the assessment (the cost of the Maroochydore rail extension was found to exceed its benefits), with the other five being proposed without completed assessments.

Terrill says it’s prudent to be stepping back from last election’s megaproject binge. For some years, the engineering construction industry has been warning about its limited capacity to deliver the existing pipeline of projects, let alone add to it. Even before the pandemic, employment in the sector had surged by half, and supply-chain disruptions had made it slower, more difficult and more expensive to find materials.

With the recent slowing in population growth, maintaining and upgrading existing assets should take priority over big new projects. But both parties have promised to spend more on new projects than upgrades. Pollies always prefer the flashier projects.

But while big projects are down, tiny projects are way up. Two-thirds of the Coalition’s promised spending is on projects costing $30 million or less, and nearly half of Labor’s. We’re talking commuter station car parks and roundabouts.

My guess is this is about spending less money overall on projects targeted towards many more key electorates. That is, it’s about greater vote-buying efficiency. Presumably, the voters in these seats find the projects attractive.

But that doesn’t make the money well-spent. Terrill reminds us these tiny, hyper-local projects violate a longstanding principle that the Feds stick to infrastructure of national significance, leaving the small stuff to state and local governments.

They know a lot more about what’s most needed where, meaning that when the feds blunder in with their vote-buyers, things often go amiss. Many commuter car parks promised at the last election had to be cancelled, Terrill says, because there were no feasible design options, feasible sites or because the rail station was being merged with another.

How were the young political staffers with their whiteboards in Canberra supposed to know that?

Terrill notes two further objections. First, “the quality of the projects promised in the heat of election campaigns is poor,” she says. The tiny projects are too small to be assessed by Infrastructure Australia and, as we’ve seen, the big ones get promised without completing proper assessment.

Second, she says, “government decisions should be made in the public interest, and those making the decisions should not have a private interest – including seeking political advantage with public funds”.

“A better deal for taxpayers would be for whichever party wins government on Saturday to halt this spending on small local infrastructure, and focus instead on nationally significant projects that have been properly assessed by Infrastructure Australia,” Terrill says.

In an earlier report, Terrill argued that the next government should strengthen the transport spending guardrails. It should “require a minister, before approving funding, to consider and publish Infrastructure Australia’s assessment of a project, including the business case, cost-benefit analysis, and ranking on national significance grounds”.

This would go a long way towards increasing the social and economic benefit from projects, while reducing their use to buy votes with taxpayers’ money.

And all that’s before you get to cost-overruns. Back in 2020, Terrill reported that the Inland Railway was originally costed at $4 billion, whereas the latest estimate was $10 billion. Melbourne’s North-East Link had gone from $6 billion to $16 billion. The Sydney Metro City & Southwest underground had gone from $11 billion to $16 billion. Incompetence or deliberate understatement?

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Modern politics goads us to be greedy, and forget the needy

Mark, a voter in the Melbourne electorate of Higgins, told the ABC’s Virginia Trioli this would be the last federal election he’d be alive to vote in. So he’d decided his vote should not be for him, but for the younger generation coming after him.

He wanted to cast his final vote for the party that best represented young people’s aspirations for their future. So he went to the local high school and got permission to talk to the senior students.

And which side did they pick? “It’s the Greens. And that’s the first and last time I’ll be voting for them,” he said.

It’s a sad commentary on modern politics that no mainstream politician would dare suggest we vote for them because they’d best advance the public interest. They know that we know their greatest interest is in advancing their own career so, to attract our votes, they offer bribes.

They’ve trained us to see elections as transactional, not aspirational. You want my vote? What are you offering? And is that better or worse than the other side’s offering?

That’s how, with climate change and so many other, lesser problems needing attention, we’re devoting most of this campaign to grappling with the great challenge of our age ... the cost of living. Really?

Now, I don’t blame people on low incomes with big commitments who really do struggle to get by for wanting to see what the two sides are offering that might make their lives easier.

But you don’t have to be struggling to tell yourself your life’s a struggle, and you wouldn’t mind voting for a pollie offering you a few more bangles and baubles.

I can’t be the only voter in the land whose comfortable lifestyle is not in any way threatened by the rising cost of living.

A reminder from Struggle Street would be timely. My co-religionists, the Salvos, release today a report on how their clients are faring, preparatory to knocking on your door the weekend after the election. (If you’re wondering, at present I hold the rank of backslider, but there’s still a lot of Salvo in me.)

The Salvos took a random sample of 10,000 of the people who had attended their emergency relief centres in the past 12 months. More than 1400 people responded to the request to complete an online questionnaire.

The survey showed that, after paying for housing costs, 93 per cent of respondents were living below the poverty line, with almost two-thirds needing to ask for financial help from family and friends.

The high proportion of these people’s meagre incomes devoted to rent is their biggest problem, leaving too little for food and all the rest.

Although some respondents would be working poor, most would be on government support payments, including the parenting payment and disability support payment. Among these people, 60 per cent say they can’t afford medical or dental treatment when they need it, and well over half say they’re going without some meals.

Dr Cassandra Goldie, head of the Australian Council of Social Service, reminds us that poverty isn’t an unfortunate but unavoidable fact of life, it’s a policy choice. We have a system of support payments that’s supposed to keep people out of poverty, but choose to set the payment level below the poverty line.

A recent national poll of 1000 adults commissioned by ACOSS and conducted by Ipsos has found that 76 per cent of respondents say they couldn’t live on $46 a day, the present rate of Jobseeker. Two-thirds agree the rate should be above the poverty line, which is $70 a day.

When the first lockdown in 2020 prompted the Morrison government to almost double the rate of Jobseeker, the payment rose above the poverty line. People couldn’t believe how much easier their lives had become, and requests for help from outfits like the Salvos fell away – although many overseas students and other holders of temporary visas needed feeding.

But Scott Morrison’s Christian charity lasted only six months. In the end, the biggest permanent increase he could afford was $6 a day. Need for help from the Salvos has returned. In this campaign, however, Morrison has been able to promise various new benefits to self-funded retirees who, by definition, are too well-off to qualify for the age pension.

When Anthony Albanese abandoned Labor’s promise from last election to review the level of unemployment benefits, he pointed to the big budget deficit he’d inherit. I can see his problem. If he were to spend more helping people living below the poverty line, how could he afford the $9000-a-year tax cut he (like Morrison) has promised me and my ilk in 2024? He’s saving up.

Last word to my superior officer, the Salvos’ Major Bruce Harmer: “We’re calling on the next elected federal government to focus on the most vulnerable in society. Being able to meet basic living expenses should be the norm for all in an advanced economy like Australia, and not something we are still discussing in 2022.” Amen to that.

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Inflation: workers being unreasonable, or bosses on the make?

When you think about it clearly, the case for minimum award wages to be raised by 5.1 per cent is open-and-shut. So is the case for all workers to get the same. This wouldn’t stop the rate of inflation from falling back towards the Reserve Bank’s 2 to 3 per cent target zone.

But if, as seems likely, the nation’s employers contrive to ensure that this opportunity is used to continue and deepen the existing fall in real wages, the nation’s businesses will have shot themselves in the foot.

What, in their short-sightedness, they fondly imagined was a chance to increase their profits, would backfire as this blow to households’ chief source of income, crimped those households’ ability to increase or even maintain their spending on all the things businesses want to sell them.

The recovery from the “coronacession” would falter as households’ pool of savings left from the lockdowns was quickly used up, and their declining confidence in the future sapped their willingness to run down their savings any further.

Should the economy slow or even contract, unemployment could rise and the hoped-for gain in profits would be lost. Cheating your customers ain’t a smart business plan.

Such short-sighted thinking by businesses involves a “fallacy of composition” common in macro-economics: what seems “rational” behaviour by an individual firm doesn’t make sense for firms as a whole. It’s a form of “free-riding”: it won’t matter if I screw my workers because all the other businesses won’t screw theirs.

But back to wages. If all workers got a 5.1 per cent pay rise to compensate them for the 5.1 per cent rise in consumer prices over the year to March, thus preserving their wage’s purchasing power, surely that means the inflation rate would stay at 5.1 per cent?

Firms would have to raise their prices by 5.1 per cent. But many small businesses wouldn’t be able to afford such a huge pay rise and would give up, putting all their workers out of a job.

Is that what you think? It’s certainly what the employer-group spruikers want you to think. But it’s nonsense. Hidden within it is a mad assumption, that wages are the only cost a business faces.

Unless all those other costs have also risen by 5.1 per cent, the business can pass on to its customers all the extra wage cost with a price rise of much less than 5.1 per cent.

How much less? That’s a question any competent economist could give you a reasonably accurate answer to by looking up the Australian Bureau of Statistics’ most recent (for 2018-19) “input-output” tables and doing a little arithmetic.

The tables divide the economy into 115 industries, showing the value of all the many inputs of raw materials, machinery, labour, rent and other overheads to the process by which the industry produces its output of goods or services.

Any competent economist (which doesn’t include me, I’m just a journo) could do this, but only two economists from the Australia Institute, Matt Saunders and Dr Richard Denniss, have bothered, in a paper forthcoming this week, Wage price spiral or price wage spiral?

The official tables show that the proportion of total business costs accounted for by labour costs (that is, not just wages, but also “on-costs” such as employer super contributions and workers comp insurance) varies greatly between industries, ranging from less than 3 per cent in petroleum refining to almost 71 per cent in aged care.

But this “labour/cost ratio” averages just 25.3 per cent across all 115 industries.

Now, let’s assume all workers in all industries received a 5 per cent pay rise, and all businesses chose to pass all the extra cost through to prices. By how much would prices rise overall? By 1.27 per cent.

That’s going to keep inflation soaring? It’s well below the Reserve’s 2 to 3 per cent target range.

Of course, that’s just what economists call “the first-round effect”. What about when all a firm’s suppliers put their prices up to cover their wage rises? The “second-round effect” takes the overall rise in prices from 1.27 per cent to 1.85 per cent – still below the target.

Do you remember when the ABC quoted some spruiker saying the cost of a cup of coffee in a cafe could rise to $7? The authors use the tables to show that passing on a 5 per cent pay rise could increase the retail price of a $4-cup by 9 cents.

(Such people are always telling us a crop failure in South America has doubled or trebled the price of coffee beans. It’s the same trick: they never mention that the cost of beans is the least part of the price of a coffee. The biggest cost is often renting the cafe.)

Now get this. That 1.85 per cent rise in prices probably overstates the effect of a universal 5 per cent wage rise, for three reasons.

First, because it assumes zero improvement in the productivity of labour. It’s not great at present, but it’s not non-existent. Second, it assumes firms don’t respond to higher costs by shifting to cheaper substitutes.

And third, because six of the 10 “industries” with the highest labour cost pass-through are either government departments (which don’t actually charge a price that shows up in the consumer price index) or are heavily subsidised by government. Effect on the budget isn’t the same as effect on inflation.

Note that whereas the Fair Work Commission has the ability simply to order a 5 per cent rise in the many minimum award rates covering the lowest-paid quarter of the workforce, should it choose to, the public and private sector employers of the remaining three-quarters of workers are unlikely to be anything like that generous.

That’s a fourth reason the effect of wage rises is likely to be (a lot) less than the authors’ simple calculation of a 1.85 per cent rise in retail prices.

But don’t get the idea wages are the only reason consumer prices rise. Wage rises would explain little of the 5.1 per cent rise in consumer prices over the year to March.

The great bulk of the rise is explained by businesses passing on to retail customers the higher prices of imported goods and services caused the pandemic’s various supply disruptions and the Ukraine war’s effect on energy and food prices.

But some part of that 5.1 per cent rise in prices is explained by businesses deciding now would be a good time to raise their prices and fatten their profit margins. This may not be a big factor so far, but I won’t be surprised if it’s a much bigger one this quarter and in future.

For months the media have been telling us how much a problem inflation has become, with a lot worse to come. Top business leaders and industry lobbyists have used naive reporters to, first, send their competitors a message that “we’re planning big prices rises so why don’t you do the same” and, second, soften up their customers. “Prices are rising everywhere – don’t pick on me.”

It’s quite possible we’ll have trouble getting inflation back into the target range. If so, it won’t be caused by big pay rises – but it’s a safe bet people will be using a compliant media to blame it on greedy workers.

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Cutting real wages will help inflation, but weaken the economy

At last, as the election campaign reaches the final stretch, we’ve found something worth debating. Anthony Albanese has found his spine and supported a big rise in award wages, while Scott Morrison says a decent rise for the masses is a terrible idea that would damage the economy.

First the politics, then the economics. My guess is history will judge this to be the misstep that did most to cost Morrison the election. Successful Liberal leaders – John Howard, for instance – know never to be caught within cooee of a sign saying “wages should be lowered”. It’s not the way to woo outer-suburbs battlers to the Liberal cause.

That Morrison should defy this precedent in a campaign where the cost of living has become by far the biggest issue is all the more surprising.

Between them, the two contenders have revived and highlighted the oldest stereotype in Australia’s two-party politics: the Labor Party is - surprise, surprise – the party of ordinary workers, and will always champion their interests, whereas the Liberals are the party of business, and will always champion the interests of business.

It’s because the Libs are seen as the bosses’ party that they’re instinctively regarded as better at managing the budget and the economy – a mindset Morrison is desperately seeking to exploit in “these uncertain times”.

But the other side of the penny is that Labor, the party of the workers, is the party that cares, and will spend more on providing government services. Which party’s best at industrial relations and wages? One guess.

But how do the minimum wage arrangements work? And what are the broader economic implications of a rise high enough to cover the 5.1 per cent rise in consumer prices over the year to March - or not high enough, so that wages fall in “real terms”?

The Fair Work Commission conducts an annual wage review to determine the increase in the national minimum wage on July 1. Last year’s increase of 2.5 per cent applied to the 2 per cent of employees on the national minimum rate, but also the 23 per cent of employees whose wage is set by one of the various minimum rates for workers in different job classifications set out in each of the more than 100 industrial awards established by the commission.

The national minimum wage rate is about $20 an hour, or about $40,000 a year for a full-time worker. About 2.7 million workers have their wage set in this way.

A 5 per cent increase in the national minimum wage would be worth about $1 an hour or about $2000 a year. Note, however, that many of those in more skilled award classifications would be earning much more than that.

The rises the industrial parties ask for in hearings before the commission are always “ambit claims”. The Australian Council of Trade Unions wants a rise of 5.5 per cent.

On the employer side, the Australian Industry Group says the most its member businesses could possibly afford is 2.5 per cent. The Australian Chamber of Commerce and Industry says the most it could run to is 3 per cent.

Morrison has implied it would be quite improper for a federal Labor government to seek to influence the decision of the independent commission. But the fact is federal and state governments routinely make submissions to provide information about the state of the economy and indicate how generous or tight-fisted they think the commission should be – though they rarely suggest a specific figure.

The commission will give due consideration to a government’s submission but, rest assured, it will do as it sees fit, usually awarding an increase somewhere between the employers’ lowball and the unions’ highball.

My guess is this year’s decision will be a lot higher than last year’s 2.5 per cent, but not nearly as high as 5.5 per cent.

That’s particularly because the commission can be expected to allow for the 0.5 percentage-point increase in employers’ compulsory contributions to their workers’ superannuation accounts this July. The unions would love to have their cake and eat it, but I doubt they’ll be allowed to.

Albanese says, “the idea that people who are doing it really tough at the moment should have a further cut in their cost of living is, in my view, simply untenable”.

Morrison claims a minimum-wage increase sufficient to stop wages falling behind the rise in consumer prices would be “reckless and dangerous”.

The Ai Group warns that “an excessive minimum wage increase would fuel inflation and lead to higher interest rates . . . than would otherwise be the case”. It would be detrimental to economic growth and job creation.

The chamber of commerce says “any increase of 5 per cent or more would inflict further pain on small business, and the millions of jobs they sustain and create. Small business cannot afford it”.

So, what do I think? I think it’s easy to exaggerate the economic cost of giving our lowest-paid workers a decent pay rise. Small business always cries poor and warns jobs will be lost. But there’s little empirical evidence that higher wages lead to job losses.

It’s true that giving a quarter of our workers little or no compensation for the jump in prices caused by pandemic supply disruptions and the Ukraine war would be the quickest and easiest way to get inflation back down to the Reserve Bank’s 2 to 3 per cent target range.

But it would also be hugely unfair to load that burden onto our lowest paid workers, while business profits escaped untouched. The Reserve will just have to be more patient if it doesn’t want to crunch the economy with big rate rises.

And here’s the bit the business lobby groups seem too short-sighted to see. The more we cut the real incomes of our businesses’ customers, the less businesses will be able to sell to them, and the more the economy will be in anything but the “strong” condition Morrison keeps claiming it’s in.

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In this election, one critical issue stands above all others

In this campaign we face a bewildering array of problems needing attention: the punishing cost of homes, the appalling treatment of people in aged care, the high cost of childcare, the neglect of every level of our education system, the continuing destruction of our natural environment and the pressure on our hospitals, not to mention the cost of living.

But there’s one problem that’s the most threatening to life, livelihood and lifestyle, the most certain to get a lot worse, the most imminent and the most urgent.

It’s not the cost of living, nor the risk of war with the Solomons (I joke), nor even the dubious behaviour of Scott Morrison and his ministers and their refusal to establish a genuine anti-corruption commission.

I’ll give you a clue: as I write, my fifth grandchild is on the way. I find it hard to believe anyone could be so self-centred and short-sighted as to think any problem could be more important or more pressing than action to limit climate change.

But the pressing need to discover whether the contending pollies have memorised a list of facts and figures has left little time for debating such minor matters as which side has the better policy on global warming.

And, whatever I may think, it’s clear most voters don’t rate climate change that highly. Recent polling by the Australian National University’s Centre for Social Research and Method shows voters rank reducing the cost of living most highly (65 per cent), followed by fixing the aged care system (60 per cent), strengthening the economy (54 per cent), reducing health care costs (53.5 per cent) and – at last – “dealing with global climate change” (just under 53 per cent).

But I’m pleased to say – and you may be surprised to hear – that the nation’s economists are in no doubt on what matters most. Three-quarters of the 50 top economists surveyed by the Economic Society of Australia nominated “climate and the environment” as the most important issue for the election.

Professor John Quiggin, of the University of Queensland, says the key message from the latest report of the Intergovernmental Panel on Climate Change is that “if the world acts now, we can avoid the worst outcomes of climate change without any significant effect on standards of living”.

But the report said it’s “now or never” to keep global warming to 1.5 degrees. Action means cutting emissions from the use of fossil fuels rapidly and hard. “Global emissions must peak within three years to have any chance of keeping warming below 1.5 degrees,” he says.

If you wanted to pick the worst continent to live on as the climate changes, it would be Australia, according to Quiggin. We are a “poster child” for what the rest of the world will be dealing with. Not that we care.

The economic costs of the transition to renewable energy would be marginal, he says. “The required investment in clean energy would be around 2.5 per cent of gross domestic product. That’s far less than the cost of allowing global heating to continue, with costs further offset by clean energy’s zero fuel costs and lower operating costs.”

Voters complain there’s no real difference between the parties, but on climate change we’re being offered the full menu of varying strengths. Climate Analytics, a non-profit research group founded by Bill Hare, has assessed three parties’ policies, plus Zali Steggall’s climate bill, which the teal independents are supporting.

The Liberals have supported zero net emissions by 2050, but refused to increase their commitment to reduce emissions 26 or 28 per cent by 2030. This is judged to be consistent with global warming of 3 degrees, bordering on 4 degrees.

Labor’s target is emission reduction of 43 per cent by 2030. Its plan is supported by the Business Council of Australia. This is judged to be consistent with global warming of 2 degrees, which would be “very likely to destroy the Great Barrier Reef”.

Steggall’s climate bill has a target of 60 per cent reduction in emissions by 2030, which is close to, but within, the upper boundary of modelled 1.5 degrees pathways for Australia. A higher target would give a higher probability of meeting the 1.5 limit.

The Greens’ target of a 74 per cent reduction by 2030 is judged consistent with limiting warming to 1.5 degrees. Some parts of the Barrier Reef would survive. Globally, the most extreme heat events could be nearly twice as frequent as in recent decades. In Australia, an intense heat event that might have occurred once a decade in recent times could occur every five years and would be noticeably hotter. Phew.

If you’ll forgive a little colourful characterisation, the choice ranges from the Liberals’ “let’s just say we’ll do something, so we don’t offend Barnaby and his generous donors” to Labor’s “let’s do a lot more than the Libs, but go easy on coal and coalminers” to the Greens’ “let’s not muck about”.

And the many Liberal voters in the party’s leafy heartland who really do care about climate change now have a way to make their views felt.

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Inflation: bad for your budget, good for the government's

A big part of the Morrison government’s pitch about being better at economic management than Labor is its claim to have ensured all the massive increase in unfunded government spending during the years of pandemic lockdowns was “targeted and temporary”. Well, not really.

In a paper written by Matt Saunders and Dr Richard Denniss, of the Australia Institute, they study the forecasts and projections out to 2025-26 in the latest budget, which those with long memories will remember was presented at the start of this seemingly endless election campaign.

The authors find that, relative to what was projected in the last budget before the pandemic, annual government spending is now projected to grow at a much higher rate. It’s true annual spending has fallen back from its peak in 2020-21, but not by nearly as much as it should have if all the extra spending had been “targeted and temporary”.

So, what’s happened? I think I know. All the spending programs specifically labelled as part of the effort to hold the economy together during the lockdowns – JobKeeper, the JobSeeker supplement and all the rest – have indeed been wound up as promised.

But last year’s budget and this year’s both contained new spending initiatives that were separate to the explicitly pandemic-related measures. These, like most spending measures, were ongoing. Their annual cost tends to rise over time, in line with inflation and population growth.

If you remember, last year’s budget included much additional spending on aged care in response to the shocking findings of the royal commission, extra spending on the National Disability Insurance Scheme and a big increase in childcare subsidies.

Another thing worth remembering about last year’s budget: whatever the obvious political motivation for that additional spending, the econocrats co-opted it for their Plan B: if after almost a decade trying you can’t get wages to return to their normal healthy growth, why not try getting unemployment down so low that employers have to bid up wages to get or retain the labour they need?

With under acknowledged help from the temporary closure of our borders to all imported labour, Plan B has worked so well it’s now adding to the risk of ongoing inflation arising from all the once-off imported inflation.

But perhaps the most startling thing revealed by the authors’ examination of the budget papers is the way, relative to the pre-pandemic figures, nominal gross domestic product is now projected to grow at quite a faster rate than real GDP.

Why would nominal grow faster than real? Clearly, because of a higher rate of inflation. Remember, however, here we’re talking about inflation measured not as usual by the consumer price index, but as measured by the “GDP deflator”.

Why would the two inflation measures give significantly different results? Because our “terms of trade” had changed. If the prices we receive for our exports are changing at a different rate from the prices we’re paying for our imports.

So the GDP deflator includes changes in export prices, and subtracts changes in the prices of imports, whereas the CPI ignores export prices, but does include changes in the retail prices of imported consumer goods and services.

We’ve been making so much fuss about the bad news of rising import prices, such as petrol and diesel, we’ve forgotten that, as a big exporter of energy and food, we’re a net beneficiary of the Ukraine war’s effect on world commodity prices.

With much additional help from high iron ore prices, our terms of trade improved by more than 12 per cent in the March quarter, to a record high. A record high, and no one noticed.

But here’s the trick: your personal budget benefits only indirectly, if all at, from our booming exports. But it will bear the full effect of higher import prices, which do most to explain why the cost of living is up 5 per cent in a year and headed higher.

The Reserve Bank is confident this year’s round of wage rises will be a fair bit higher than last year’s, but it is adding to home-buyers’ cost of living by putting up interest rates, to help ensure wages rise by a lot less than prices in the period ahead.

So, recent developments not good news for your budget, but great news for the government’s budget. Its revenue tends to grow in line with the growth in nominal GDP. And higher inflation means higher taxes.

Mining companies paying more company tax, consumers paying more goods and services tax and, even despite the continuing fall in real wages, higher income tax collections as whatever wage rise workers do get pushes them into higher tax brackets or otherwise raises their average tax rate. Good news for some.

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Our falling real wages will help control inflation

The media always portray an increase in interest rates as terrible news – and it’s hardly surprising that’s how Anthony Albanese sees it – but Scott Morrison is right in saying rising interest rates are a sure sign of a strong economy.

Rates fall or stay low when the economy is weak, but rise when the economy’s strong growth threatens to give us a problem with high and rising inflation – which is where we are now.

One of the main things we want from a strong economy is lots of jobs, which is just what we’ve been getting. So many jobs have been created over the past two years – almost all of them full-time – that the rate of unemployment has fallen to a very low 4 per cent, and the proportion of working-age people with jobs is higher than it’s ever been.

What could be wrong with that? Well, just that the wages people have been earning from all those jobs haven’t been keeping up with the cost of living. Last week’s news that consumer prices rose by a massive 5.1 per cent over the year to March has made that much worse.

If you want to blame Morrison for that, well, he’s actually right in saying most of its causes – supply disruptions arising from the pandemic; high petrol prices caused by Russia’s war on Ukraine – have nothing to do with our government.

But wages have been struggling to keep up with prices for all the time this government’s been in office. There are things it could have been doing to encourage higher wages, but it’s failed to do them. That’s the legitimate criticism of Morrison’s economic management.

Getting back to interest rates, the truth is that a rise in rates cuts both ways. It’s bad news for people with home loans, but good news for older people living on their savings and for young people saving for a deposit on a home.

Did I mention that nothing’s ever black or white in the economy? Almost everything that happens has advantages for some people and disadvantages for others.

But leaving aside whether individuals gain or lose from higher interest rates, where does the jump in prices leave the economy? How much of a worry has inflation become? Will rates have to rise so high they threaten the recovery? Could we even end up back in recession?

This time last week some business economists were sounding pretty panicky. “The inflation genie is well and truly out of the bottle”, some assured us. Others claimed the economy was “overheating” and, since the Reserve Bank had left it so late to start raising rates, they’d have to rise a long way to get inflation back under control.

But when Reserve governor Dr Philip Lowe announced on Tuesday that the official interest rate – aka the “overnight cash rate” – had been increased by 0.25 percentage points to 0.35 per cent, warned that further rises in rates will be needed “over the period ahead”, and explained how he saw the problem and how it could be fixed, many economists seem to have calmed down.

Implicitly, Lowe refuted the claim that the economy was overheating. Even at 5.1 per cent, our inflation rate was lower than the other rich countries’, and our wage growth so far had been much lower.

So the rise in inflation “largely reflects global factors” – that is, not of our making – but “domestic capacity constraints are increasingly playing a role and inflation pressures have broadened, with firms more prepared to pass through cost increases to consumer prices”.

That is, we don’t have as big a problem as that 5 per cent figure could make you think, but the economy’s growing so strongly we could get a problem if we kept interest rates so low.

Many retailers and other firms have gone for years trying to hold down their costs, including by finding ways to save on labour costs, and avoid passing those costs on to customers, but the rise in their pandemic and Ukraine-related costs – plus the media’s incessant talk of rising prices – has emboldened them to start increasing their own prices.

Now, as Lowe explains, even if petrol and pandemic-related costs don’t fall back down, they won’t keep rising. So in time the inflation rate will fall back of its own accord, provided it doesn’t lead to our firms putting their prices up too high and giving their workers pay rises big enough to fully cover their higher living costs.

If that does happen, the once-only rise in prices coming from abroad gets into the wage-price spiral and the inflation rate stays high.

This is why Lowe has started raising the official interest rate and may keep raising it by 0.25 percentage points every month or so until, by the end of next year, it’s up to maybe 2.5 per cent (which, not by chance, is the mid-point of the Reserve’s 2 to 3 per cent inflation target).

Note that, if 2.5 per cent is roughly equal to the “neutral” interest rate - that is, the rate that’s neither expansionary nor restrictive – this would only involve withdrawing the “extraordinary monetary support” put in place to help us through the pandemic. It would take the Reserve’s foot off the accelerator, not jam on the brakes.

According to Lowe’s estimations, the resulting reduction in mortgagees’ disposable income, plus the likelihood that most workers’ wage rises wouldn’t be sufficient to cover the 5 per cent rise in their living costs, thus reducing their wages in real terms, would limit firms’ ability to raise their prices and so help to get the inflation rate back to the top of the 2 to 3 per cent target range by 2024.

The inflation problem fixed, without crashing the economy. Done at the expense of people with home loans and ordinary workers? Yep. No one said using interest rates to control the economy was particularly fair.

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Election bottom line: taxes will be going up, not down

Whichever side wins this election, it will be taking on a serious budget problem. Both sides are promising increased government spending on various worthy causes, while also promising that taxes will be cut rather than increased. This implies an ever-growing budget deficit. Do you think either side could get away with that? Only in their dreams.

Modern politicians are quite dishonest in what they tell us during election campaigns. They speak in loving detail about the expensive goodies they’re promising, but avoid mentioning any bad things they might have to do. They never present us with the bill.

And then we wonder why so many promises are broken.

Even before it thinks about the future, the new government will have to deal with unfinished business. The budget Treasurer Josh Frydenberg produced at the start of this campaign projected significant deficits for at least the next 10 years.

This despite the worst of the pandemic being over, and almost all the stimulus programs intended to keep the economy going during the lockdowns having been wound up. And despite the rate of unemployment being at its lowest in 50 years.

Economists know this profligacy will have to be corrected soon. Treasury secretary Dr Steven Kennedy has hinted as much. But that will require unpopular cuts in government spending or increases in taxes, or both.

Scott Morrison hasn’t been interested in doing any of that prior to the election. And economists have accepted that such nasty medicine is always administered after an election, not before.

The pollies won’t warn you of this, but I can. The longer the new government hesitates, the more the Reserve Bank will be obliged to compensate by raising interest rates higher than it otherwise would need to.

But that’s just the first of the budget problems the new government will inherit. The next part is that though – as the failure of its first 2014 budget demonstrated – the Coalition lacks the courage to make deep cuts in major spending programs, it has cut areas of spending that lack political support and kept a lid on spending in areas it hoped wouldn’t be noticed.

One of these tricks is to allow waiting lists and waiting times to blow out. Whenever you hear the word backlog – or spend ages on the phone waiting for “your call” to be so “important to us” that it’s actually answered – you know somebody somewhere is trying to save money by cutting the quality of the service you’re getting.

But penny-pinching is a game you can play for only so long before the worm turns. And after nine years, the pipsqueaks have started squeaking.

Did you catch the story just before budget night of the Minister for Veterans’ Affairs, Andrew Gee, who had to threaten to resign before the government relented and gave him extra funding to reduce the backlog in processing claims from veterans? (This from the guys always so sanctimonious on Anzac Day.)

High on the list of cost cuts is the public service. Who cares about all those shiny bums? Well, when you have trouble rolling out vaccinations, or getting hold of enough RATs, maybe you wonder whether it was smart to show so much knowledge and expertise to the door.

Overseas aid is another favourite for cost cutting, and we haven’t been as generous as we could be with our Pacific neighbours. Do you think, say, the Solomon Islanders might have noticed?

The diplomatic corps is another needless extravagance we’ve cut back on. More economic to wait until our relations with big neighbours deteriorate to the point where we need to spend infinitely more on defence preparedness.

Then there’s the notion that $46 a day is plenty for the unemployed to live on. How much longer do you think governments will be able to get away with that outright meanness? Especially when both sides are planning to give battlers like me a $9000-a-year tax cut in 2024.

It’s already clear the jig is up in one of the biggest areas where successive governments have tried to keep a lid on costs: aged care.

A fair part of those endless projected budget deficits is the $17 billion additional spending on aged care in last year’s budget, following the damning report of the royal commission. But there’ll need to be much further spending on care workers’ wages and training before standards are acceptable.

And that’s before you get to the big increases in spending on the National Disability Insurance Scheme and on defence.

Everything points to strong growth in government spending in coming years. And with budget deficits needing to be smaller rather than larger, this points to taxes that are higher.

Which taxes? Obvious candidates are reduced superannuation tax concessions for high earners like me, plus higher user charges for aged care. But the big one will be more bracket creep. Higher inflation equals higher income tax.

Don’t believe any politician who claims to stand for lower taxes. They can’t deliver.

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Our inflation problem isn't a big one - unless we overreact

I can’t remember a time when the arguments of all those bank and business economists claiming “the inflation genie is well and truly out of the bottle” and demanding the Reserve Bank raise interest rates immediately and repeatedly have been so unconvincing.

At base, their problem is their unstated assumption that the era of globalisation means all the advanced economies have identical problems for the same reasons and at the same time.

If America has runaway inflation because successive presidents have applied budgetary stimulus worth a massive 25 per cent of gross domestic product at the same time as millions of workers have withdrawn from the workforce, Britain’s withdrawal from the European Union is causing havoc, and Europe’s problem is particularly acute because of its dependence on Russian oil and gas, we must be the same.

Business economists have put most of their energy into convincing themselves our problem is the same as everyone else’s, rather than thinking hard about how our circumstances differ from theirs and how that should affect the way we respond.

There’s also been a panicked response to a huge number – inflation of 5 per cent! – that says, “don’t think about what caused it, just act”. And since every other central bank has already started raising rates, what’s wrong with our stupid Reserve?

Too many economists have switched their brains to automatic pilot. We know from our experience of the 1970s and ’80s how inflationary episodes arise – from excessive demand and soaring wages – and we know the only answer is to jack up interest rates until you accidentally put the economy into recession. You have to get unemployment back up.

That stereotype doesn’t fit the peculiar circumstances behind this rise in prices, nor does it fit the way globalisation, skill-biased technological change, the deregulation of centralised wage-fixing and the huge decline in union membership have stripped employees of their former bargaining power.

The first thing to understand is that our price rises have come predominantly from shocks to supply: the various supply-chain disruptions caused by the pandemic, the war on Ukraine’s effect on oil and gas prices, and climate change’s effect on meat prices.

Various economists are arguing that price rises have been “broadly based” so as to show that price rises are now “demand-driven”, but the main reason so many prices have risen is that there have been so many different supply shocks coming at the same time, with so many indirect effects, ranging from transport costs to fertiliser and food.

Two thirds of the quarterly increase in prices came from four items. In order of effect on the index: cost of new dwellings (up 5.7 per cent), fuel prices (11 per cent), university fees (6.3 per cent) and food (2.8 per cent).

Of those, only new dwelling prices can be attributed mainly to strong demand, coming from the now-ended HomeBuilder stimulus measure. The rise in uni fees was a decision of the Morrison government.

America’s economy is “overheating”, but ours isn’t. It’s true our jobs market is very tight, and that much of this strength is owed to our now-discontinued stimulus measures.

But, paradoxically, the economics profession’s ideological commitment to growth by immigration has blinded it to the obvious: job vacancies are at record levels also because of another pandemic-related supply constraint: our economy has been closed to all imported labour (and we even sent a fair bit of it back home). This constraint has already been lifted.

The thing about supply shocks is that they’re once-only and not permanent. So, left to its own devices, without further shocks the rate of price increase should fall back over time. Petrol and diesel prices, for instance, have already fallen a bit but, in any case, won’t keep rising by 35 per cent a year year-after-year.

It’s sloppy thinking to think a rise in prices equals inflation. The public can be forgiven such a basic error, but professional economists can’t. A true inflation problem arises only when the rise in prices is generalised and is ongoing. That is, when it’s kept going by a wage-price spiral.

When a huge rise in prices, from whatever source, leads to an equally huge – or huger – rise in wages, which prompts a further round of price rises. That’s inflation.

In their panic, business economists have assumed that the loss of employee bargaining power we’ve observed in most of the years since the global financial crisis, which has done so much to confound the econocrats’ wage and growth forecasts, and caused inflation to fall short of the Reserve’s target range for six years in a row, has suddenly been transformed. Union militance is back!

Really? I’m sure employees and what remains of their unions will be asking for pay rises of at least 5 per cent this year, but how many will get anything like that much? They’ll all be on strike until they do, you reckon?

They’re safe to get more than the 2.3 per cent they got in the year to December, according to the wage price index, but the greatest likelihood is that real wages will continue to fall. And the cure for that is to raise interest rates, is it?

It is true that, if wages rose in line with prices, we would have an inflation problem, but how likely is that?

There’s been much concern about stopping a rise in “inflation expectations”, but this thinking involves a two-stage process: in expectation of higher inflation, businesses raise their prices. And in expectation of higher inflation, unions raise their wage demands.

All the sabre-rattling we’ve seen by the top retailers and their employer-equivalent of union bosses – so breathlessly reported by the media – suggests they’re increasingly confident they can get away with big price rises. But how much success individual employees and unionised workers have in realising their expectations remains to be seen.

Perhaps in this more inflation-conscious environment, employers will be a lot more generous – more caring and sharing – than they have been in the past decade. Perhaps.

The Reserve is under immense pressure from the financial markets, the bank and business economists, the media, the actions of other central banks and even the International Monetary Fund to start raising interest rates.

It will, with little delay. It must be seen to act. But whether it’s at panic stations with the media and the business economists is doubtful. And you don’t have to believe the inflation genie is out of the bottle to see that the need for interest rates to be at near-zero emergency levels has passed.

As BetaShares’ David Bassanese has predicted, the Reserve will be “not actively trying to slow the economy, but rather [will] begin the process of interest-rate normalisation now that the COVID emergency has passed”. Moving to “quantitative tightening” will be part of that process.

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FISCAL POLICY & MONETARY POLICY: PROSPECTS FOR THE POST-COVID RECOVERY

 The pandemic isn’t over, but with most of our population vaccinated, we can hope that the worse of it is over and it won’t greatly disrupt the economy in future. Australia has had great success in containing the virus, and the “coronacession” has proved to be much shorter and shallower than expected. The economy has bounced back from each of the two periods of lockdown, the unemployment rate has fallen to its lowest in almost 50 years and strong growth of a bit over 4 pc is expected in calendar 2022. However, global supply-side shocks have lifted the inflation rate to 5.1 pc over the year to March, and it’s expected to go a bit higher before it starts falling back. To ensure the strong economy doesn’t cause the once-only supply-side price rises to get built into the wage-price spiral, the Reserve Bank has begun increasing the official cash rate to withdraw the “extraordinary monetary support” put in place to help the economy through the pandemic. The government is likely to come under pressure from macro-economists to tighten fiscal policy somewhat for the same reason.

Why the “coronacession” was shorter and shallower than expected

What I call the “coronacession”, which ended Australia’s record run of almost 30 years without a recession in the March quarter of 2020, proved to be much shorter and shallower that originally feared. The initial, nation-wide lockdown in the economy caused real GDP to contract by more than 7 pc in the March and June quarters of 2020. The unemployment rate peaked at 7.5 pc in July 2020, and the under-employment rate peaked at 11.4 pc in September 2020. But, to everyone’s surprise, GDP rebounded strongly in the following two quarters, to end 2020 just 1 pc below where it was in December 2019. Then followed a second lockdown in NSW, Victoria and ACT, which caused real GDP to contract by 1.9 pc in the September quarter of 2021, before bouncing back with growth of 3.4 pc in the December quarter after the lockdown ended. By coincidence, the net growth in real GDP over the two years to December 2021 was also 3.4 pc.

The latest figures for the labour market, for March 2022, show net growth in employment of more than 390,000 jobs in two years, almost all of which were full-time. The rate of unemployment had fallen to 4 pc and the rate of underemployment to 6.3 pc. The participation rate was at a record 66.4 pc, and the proportion of the working-age population with jobs at a record 53.8 pc. Remember, however, that this amazing performance was assisted by the temporary closing of our borders to “imported labour” during the worst of the pandemic. Immigration has now resumed.

Four main factors explain why the coronacession proved shorter and shallower than originally expected. First, the virus wasn’t as virulent as first feared by epidemiologists and our hospital system was stretched but not overwhelmed. We took advantage of our island status to close our borders, all states co-operated in limiting the spread of the virus, a vaccine became available and was distributed far sooner than originally expected, and we didn’t have a big problem with anti-vaxxers or people refusing to wear masks.

Second, the coronacession can’t be compared with an ordinary recession. Whereas ordinary recessions are caused by weak demand by households and firms, the corona recession was caused by a government-ordered temporary cut in supply, as federal and state governments sought to suppress the virus by closing our borders, ordering many industries to cease trading, and requiring people to leave their homes as little as possible. This meant that, when the lockdowns were lifted, people and businesses were able to resume (almost) normal activity. The JobKeeper wage subsidy program was designed to keep workers attached to their employers until the lockdown ended. The temporary JobSeeker supplement was intended to help anyone who did lose their job to keep spending. The two programs were highly effective.

Third, the rebound strategy was hugely effective in restoring employment to roughly where it was before the lockdown. However, the rate of unemployment has fallen by more than would normally happen in response to such a rise in employment. This is because the closing of our border to immigrants caused the size of the labour force to grow by about half the rate it normally does, thus making it easier for increased employment to lead to reduced unemployment.

Fourth, when you remember the massive amount of fiscal stimulus the federal government has applied – more than $300 billion, or about 15 pc of GDP - it shouldn’t be so surprising that the economy has grown so strongly. What this proves is that fiscal stimulus works.

Households have yet to spend much of the stimulus money and ordinary income they received over the past two years. Household saving as a proportion of household disposable income is an unusually high 13.6 pc, and households have an extra $240 billion in bank accounts. Because of this, and because so many people have jobs, the outlook for the economy at present is unusually strong. Real GDP is expected grow by a huge 4 pc or more in calendar 2022, but slow to a below-trend 2 pc in 2023 (because population growth won’t be back to normal). The unemployment rate is expected to fall further to 3.5 pc.

The return of inflation

Like all the advanced economies, Australia had enjoyed low inflation in the RBA’s target range of 2 to 3 pc on average since the mid-1990s. But over the past few quarters we’ve been hit by an unusual coincidence of global supply-side price shocks arising from disruptions caused by the pandemic, by Russia’s attack on Ukraine causing a big increase in oil and gas prices, and even by climate change, with restocking since the end of the severe drought causing a jump in beef and lamb prices. The “headline” inflation rate rose to 5.1 pc over the year to March, while the “underlying” rate rose to 3.7 pc. Both are expected to rise further, with the headline rate getting to about 6 pc before starting to fall back. As a consequence of this return to inflation well above the target range, and with the economy growing strongly, in early May – during the election campaign - the RBA began increasing the official interest rate.

The policy mix returns to normal

For many years, the “policy mix” was for monetary policy to be the primary policy instrument used to achieve “internal balance” – to smooth the path of aggregate demand as the economy moves through the ups and downs of the business cycle  – with fiscal policy playing a subsidiary supporting role. This worked well when the primary policy problem was seen as high inflation rather than high unemployment.

But when the economic disruption of the pandemic arrived, with its need to lockdown the economy, the policy mix reversed, with fiscal policy becoming the main instrument, and monetary policy playing the supporting role. Governments always resort to fiscal stimulus during recessions, but this was especially necessary in the response to the pandemic because the official interest rate was already down to 0.75 pc when it began, leaving little room to cut it further.

Now, however, with the econocrats’ need to ensure the surge in imported inflation doesn’t get built into the wage-price spiral, inflation has become the big worry and monetary policy has returned to primacy in the policy mix. In any case, this year’s budget papers say the government has transitioned to the second phase of its medium-term fiscal strategy which is to “focus on growing the economy in order to stabilise and reduce debt”.

Now let’s turn to the basic facts you need to know about the two arms of macroeconomic management and how they are now being used to continue the economy’s recover from the coronacession while returning inflation to the target range.

The monetary policy “framework”

Monetary policy - the manipulation of interest rates to influence the strength of demand - is conducted by the RBA independent of the elected government. With the recovery from the coronacession now well under way, it has returned to being the primary instrument by which the managers of the economy pursue internal balance - low inflation and low unemployment. Monetary policy is conducted in accordance with the inflation target: to hold the inflation rate between 2 and 3 pc, on average, over time. The primary instrument of MP is the overnight cash rate, which the RBA controls via market operations.

Recent developments in monetary policy

Because of the seven successive years of below-trend growth since 2011-12, the Reserve Bank cut its cash rate from 4.25 pc at the end of 2011 to 0.75 pc at the end of 2019. It’s not hard to see why it kept the official interest rate low and getting lower for so long: the inflation rate had been below its target range; wage growth has been weak, suggesting no likelihood of rising inflation pressure; the economy had yet to accelerate and had plenty of unused production capacity, and the rate of unemployment showed little sign of falling below its estimated NAIRU of 5 pc, which the RBA revised down to 4.5 pc before the arrival of the pandemic.

Then the advent of the virus led the RBA to cut rates twice in one month, March 2020, lowering the rate to 0.25 pc. Despite its previously expressed reservations, it also joined the US Federal Reserve and other major central banks in engaging in quantitative easing, QE. It announced its intention to buy sufficient second-hand government bonds to ensure the “yield” (interest rate) on three-year bonds was about the same as the cash rate. And, to ensure the banks keep lending to small business during the recession, it announced it was prepared to lend to them at the same rate as the cash rate.

In November 2020, the RBA cut the cash rate even further to 0.1 pc, along with the target for three-year government bonds. It announced the further measure of spending $100 billion every six months buying second-hand government bonds with maturities of 5 to 10 years. Note that all the QE measures were intended to lower the interest rates paid by governments and private firms on longer-term borrowing. The RBA’s total purchases of second-hand bonds worth more than $350 billion are equivalent to it funding more than all the government’s fiscal stimulus by merely “printing money”.

In May 2022, following news that the inflation rate had jumped to 5.1 pc, the RBA announced its decision to raise the cash rate by 0.25 pc points to 0.35 pc to “begin withdrawing some of the extraordinary monetary support that was put in place to help the economy during the pandemic”. This would “start the process of normalising monetary conditions” and returning to “business as usual”. Ensuring that inflation returns to target over time “will require a further lift in interest rates over the period ahead”. If the goal were to return the real cash rate to “neutral” – that is, neither expansionary nor restrictive – at about 2.5 pc (the mid-point of the inflation target) by the end of 2023, the cash rate would have to be increased by 0.25 pc points every month or so. Note that this will involve the RBA taking its foot off the accelerator, so to speak, not jamming on the brakes. The RBA also announced that, having ended further QE bond purchases in February, it would now move to QT – quantitative tightening – by not “rolling over” (renewing) its bond holdings as they reach maturity.

Fiscal policy “framework”

Until the arrival of the pandemic, fiscal policy - the manipulation of government spending and taxation in the budget – had been conducted according to the Morrison government’s then medium-term fiscal strategy: “to achieve budget surpluses, on average, over the course of the economic cycle”.

Since the coronacession, however, the government has adopted a two-phase strategy. Phase one, the economic recovery plan, involved huge fiscal stimulus to promote employment, growth and business and consumer confidence. It was to remain in place until the unemployment rate was “comfortably below 6 per cent”. Phase two now involves a “focus on growing the economy in order to stabilise and reduce debt”. “This underlines the commitment to budget . . . discipline and provides flexibility to respond to changing economic conditions,” the budget papers say.

Recent developments in fiscal policy

At the time of its election in 2013, the Coalition government expressed great concern about the high budget deficit and mounting public debt it inherited, resolving to quickly get on top of both. But it turned out to lack enthusiasm for either cutting government spending or increasing taxes. And the years of below-trend growth caused by secular stagnation meant the debt kept growing and the budget didn’t return to balance until 2018-19. Mr Frydenberg was expecting the budget to return to surplus in 2019-20, but this was overturned by the pandemic, which caused the budget’s automatic stabilisers to go into reverse and return the budget to a large deficit. The government’s massive fiscal stimulus has added further to the deficit and public debt.

The budget deficit reached a peak of $134 billion (6.5 pc of GDP) in 2020-21, and is expected to fall to $80 billion (3.5 pc) in 2021-22, $78 billion (3.4 pc) in the coming financial year, 2022-23, then have fallen to $43 billion (1.6 pc) in 2025-26. The budget is projected still to be in a deficit of 0.7 pc of GDP in 2032-33. The gross federal public debt is projected to reach a peak of 44.9 pc of GDP ($1.1 trillion) in June 2025, before beginning a slow decline as a proportion of national income.

With the election over, the government is likely to come under pressure from macro-economists to tighten fiscal policy somewhat and reduce the budget deficit, so as to hasten the decline in the public debt as a proportion of GDP, as well as to help monetary policy return inflation to the target range.

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MACROECONOMIC MANAGEMENT AND THE CHANGING ‘POLICY MIX’

UBS HSC Online Economics Day

I want to talk to you today about the two “arms” or “instruments” of macroeconomic management – monetary policy and fiscal policy – used by the economic managers to stabilise aggregate demand, to smooth it out as much as possible as the economy moves through the ups and downs of the business cycle. Their goal is to achieve “internal balance” – low inflation and low unemployment – but, like most balancing acts, this combination isn’t easy to achieve and maintain. That’s because the thing that makes it easy to achieve low inflation is a low rate of growth in aggregate demand – GDP – but low growth usually means high or rising unemployment. On the other hand, the thing that makes it easy to achieve low unemployment is a high rate of economic growth, but high growth usually means rising inflation pressure, as the demand for goods and services runs ahead of the economy’s ability to supply those goods and services.

In other words, there is much potential for conflict between the two objectives of macro management, low inflation and low unemployment. They don’t easily fit together, but we do want both of them. So achieving both at the same time is the great challenge the macro managers – the RBA and the elected government, as advised by Treasury – must continually struggle to achieve.

Both policy arms should push in the same direction

In principle, both arms of policy are capable of being used either to speed up demand or slow it down. For instance, if you use monetary policy to lower interest rates, that should encourage borrowing and spending and so strengthen demand. If you use monetary policy to raise interest rates, that should discourage borrowing and spending and so weaken demand. But similarly, if you use fiscal policy to increase government spending and/or cut taxes, that should stimulate demand, whereas if you use fiscal policy to cut government spending and/or increase taxes, that should restrict demand.

Again in principle, at times when the macro managers feel they have a bigger problem with high unemployment than with high inflation, they should have both arms of policy pushing in the same direction: to strengthen demand. At times when the managers feel they have a bigger problem with high inflation than with high unemployment, they should have both arms of policy pushing in the direction of restraining demand. To put it another way, the economic managers will have more trouble achieving internal balance when, for some reason – perhaps political – they have the two arms pushing in opposite directions.

But the two arms have differing strengths and weaknesses

In practice, however, it’s often not that simple. That’s because the two arms have differing sets of strengths and weaknesses. In practice, the managers have found that monetary policy is better at slowing demand than at speeding it up. This is particularly true at times when household debt is very high – as it is at present – meaning that cutting interest rates isn’t very effective in encouraging people to take on even more debt, whereas increasing interest rates is highly effective in limiting people’s ability to keep borrowing and spending. A second reason why monetary policy is less effective in encouraging spending and more effective in discouraging spending is that interest rates in recent years have been so close to zero. There’s been little scope for them to be cut, but much room for them to be increased.

By contrast, fiscal policy is probably better at boosting demand than at slowing demand. This is mainly because the budget is controlled by politicians, who find it a lot easier to increase spending or cut taxes than to cut spending or increase taxes. To put it another way, the things you do to encourage demand are politically popular, whereas the things you do to discourage demand are politically  unpopular, so it makes sense for the encouragement to be done mainly by politicians through the budget, and most of the discouragement to be done by unelected independent bureaucrats through monetary policy.

The ever-changing ‘policy mix’

This brings us to the key decisions the economic managers must make about the relative roles to be played by the two arms at any point in time. Which of the two arms should take the lead, while the other arm plays a subsidiary, supporting role? If monetary policy is better at slowing demand, while fiscal policy is better stimulating demand, which arm plays the leading role will depend on whether, at the time, high inflation or high unemployment is the main problem. As the problem changes, so will the mixture of the two policy arms.

For many years, the “policy mix” was for monetary policy to be the primary policy instrument used to achieve internal balance, with fiscal policy playing a subsidiary supporting role. This worked well when the primary policy problem was seen as high inflation rather than high unemployment.

But when the economic disruption of the pandemic arrived, with its need to lockdown the economy, the policy mix reversed, with fiscal policy becoming the main instrument, and monetary policy playing the supporting role.

Now, however, with the all the fiscal and monetary stimulus having caused the economy to bounce back strongly from the two lockdowns, the economic managers’ greatest need is to ensure the surge in imported inflation doesn’t get built into the price-wage spiral. So inflation has become the big worry and monetary policy has returned to primacy in the policy mix. As well, this year’s budget papers say the government has transitioned to the second phase of its medium-term fiscal strategy which is to “focus on growing the economy in order to stabilise and reduce debt”. So the policy mix has returned to where it was before the arrival of the pandemic.

Now let’s look in more detail at recent developments, first in monetary policy, and then fiscal policy.

Recent developments in monetary policy

Because of the seven successive years of below-trend growth after 2011-12, the Reserve Bank had cut its cash rate from 4.25 pc at the end of 2011, to 0.75 pc at the end of 2019. It’s not hard to see why it kept the official interest rate low and getting lower for so long: the inflation rate had been below its target range; wage growth had been weak, the economy had yet to accelerate and had plenty of unused production capacity.

Then the arrival of the virus led the RBA to cut rates twice in one month, March 2020, lowering the rate to 0.25 pc. Despite its previously expressed reservations, the RBA also joined the US Federal Reserve and other major central banks in engaging in quantitative easing, QE. It announced its intention to buy sufficient second-hand government bonds to ensure the “yield” (interest rate) on three-year bonds was about the same as the cash rate.

In November 2020, the RBA cut the cash rate even further to 0.1 pc, along with the target for three-year government bonds. It announced the further measure of spending $100 billion every six months buying second-hand government bonds with maturities of 5 to 10 years. Note that all the QE measures were intended to lower the interest rates paid by governments and private firms on longer-term borrowing.

In May 2022, following news that the inflation rate had jumped to 5.1 pc, the RBA announced its decision to raise the cash rate by 0.25 pc points to 0.35 pc to “begin withdrawing some of the extraordinary monetary support that was put in place to help the economy during the pandemic”. This would “start the process of normalising monetary conditions” and returning to “business as usual”. Ensuring that inflation returns to target over time “will require a further lift in interest rates over the period ahead”. Note that this will involve the RBA taking its foot off the accelerator, so to speak, not jamming on the brakes. The RBA also announced that, having ended further QE bond purchases in February, it would now move to QT – quantitative tightening – by not “rolling over” (renewing) its bond holdings as they reach maturity.

Recent developments in fiscal policy

At the time of its election in 2013, the Coalition government expressed great concern about the high budget deficit and mounting public debt it inherited, resolving to quickly get on top of both. But the budget didn’t return to balance until 2018-19. Then the pandemic caused the budget’s automatic stabilisers to go into reverse and return the budget to a large deficit. The government’s massive fiscal stimulus has added further to the deficit and public debt.

The budget deficit reached a peak of $134 billion (6.5 pc of GDP) in 2020-21, and is expected to fall to $80 billion (3.5 pc) in 2021-22, then have fallen to $43 billion (1.6 pc) in 2025-26. The budget is projected still to be in a deficit of 0.7 pc of GDP in 2032-33. The gross federal public debt is projected to reach a peak of 44.9 pc of GDP ($1.1 trillion) in June 2025, before beginning a slow decline as a proportion of national income.

With the election over, the government is likely to come under pressure from macro-economists to tighten fiscal policy somewhat and reduce the budget deficit, so as to hasten the decline in the public debt as a proportion of GDP, as well as to help monetary policy return inflation to the target range.

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