Monday, April 30, 2012

Confirmed. What Swan needs to find to promise a surplus

Treasurer Wayne Swan has put a number on the savings he’ll need to outline Tuesday week to return the budget to surplus.

Appearing on Meet The Press Mr Swan said a collapse in projected budget revenue of $5 billion in 2012-13 and another $5 billion in 2013-14 would mean he would need to find a an extra $10 billion over the next two years.

The Age understands that only $2 billion of the $5 billion shortfall is due to weaker than expected company tax collections. Another $1 billion is due to weak collections from superannuation funds in the wake of a downturn in the share market. A further $750 million is due to weaker than expected collections of customs and excise duties on alcohol, tobacco and fuel.

Mr Swan said he would do everything within his power “to protect low and middle-income earners”, confirming that high earners on $300,000 or more would have their superannuation contributions taxed at 30 per cent rather than the present highly-concessional 15 per cent.

“We have got to make sure superannuation concessions are distributed fairly around the system and in a budget where we are looking for savings, it’s important to run your ruler over a whole range of tax expenditures to make sure that they are directed in the right areas,” he said.

Mr Swan will also tighten up further on so-called living away from home allowances under which executives hired from overseas or interstate receive large tax-free sums to compensate them for “living away from home”...

From July 1 they will have to have to prove they rent or own a second home to claim such an allowance and it will be limited to a period of one year. Fly-in fly-out workers in the mining industry will be allowed to continue to claim the allowance.

Four leading public health bodies have written to the prime minister asking for a crackdown on alcohol tax concessions as a way of stemming the tide of alcohol-related deaths and injuries and saving $1.5 billion per year.

The Australian Medical Association, the Cancer Council, the McCusker Centre for Alcohol and Youth and the Foundation for Alcohol Research and Education say taxing wine by volume at the rate applying to beer would save more than $1.5 billion and would stop the leakage of concessions to New Zealand wine makers now claiming them as part of the Closer Economic Relations agreement.

“We are aware that the Government has previously declined to act in this area, arguing that it will not act in the middle of a wine glut and where there is an industry restructure underway,” the letter says. “However research shows the current alcohol taxation arrangements actually contribute to the increased availability of very cheap wine and action is urgently required.”

The budget numbers will be boosted by a forecast of a return to economic growth of 3.25 per cent. The latest figures show growth languishing at 2.3 per cent.

Businesses taking part in the Treasury’s liason program report “strong demand” in the resources sector, a “challenging” environment in the retail sector and “difficult” conditions in manufacturing, according to a Treasury document released this morning.

The Reserve Bank will cut official interest rates by an expected 0.25 points after its board meeting Tuesday in response to weak economic growth and weak inflation. Mr Swan said the budget surplus to be unveiled Tuesday week would give the Bank “maximum flexibility” to do more in future months.

In today's Canberra Times, Sydney Morning Herald and Age

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Macklin's lament. She can't give away money

Some self-funded retirees are proud

Sometimes it’s difficult to give away money. Community services minister Jenny Macklin has $55 million in compensation she wants to hand to 281,000 self-funded retirees ahead of the carbon tax on July 1.

She has the bank account details for all but 9000 of them. Those 9000 aren’t particularly interested in receiving handouts. They haven’t given Centrelink their details because they don’t claim the existing $842.40 per annum seniors’ supplement to which they are entitled.

On offer are one-off compensation payments of $250 for each single retiree and $380 for each couple. They are due to go into bank accounts in the week beginning June 25. Any delay will see the money spent in 2012-13 rather than 2011-12, threatening an elaborate scheme designed to keep payments out of the year the budget is forecast to return to surplus.

No compensation is scheduled to be paid to pensioners or retirees in 2012-13 - the year in the carbon tax actually begins. After the upfront payment in June this year pensioners and retirees will not receive another until July 2013 when the first of the ongoing quarterly payments go into their bank accounts.

Minister Macklin yesterday called on the 9000 uninterested retirees to come forward...

“Please make sure your details are up to date with Centrelink so you get your extra assistance as soon as possible,” she said. “While Labor is delivering extra payments, Tony 0Abbott and the Liberals are planning to claw back money from self-funded retirees, pensioners and families.”

But she might find it tough. Any retiree uninterested in claiming $842.40 might also be uninterested in claiming $250. Or if they become interested they might take their time. Some of the compensation payments might go out in 2012-13 after all.

In today's Canberra Times, Sydney Morning Herald and Age

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Friday, April 27, 2012

Swan's going to cut deep - we don't know the half of it

Far from delivering the promised $1.5 billion budget surplus, Treasurer Wayne Swan is on track to deliver a deficit of $8 billion unless he cuts far harder than he had been planning according to a private sector analysis traditionally delivered a week before the budget.

Macroeconomics, a consultancy run by former Treasury modeller Stephen Anthony finds the 2012-13 budget position $10 billion worse than forecast in the government’s November mid-year update.

Most of the collapse is due to a $6 billion shortfall in company tax revenue compared to what was expected at the time of the update.

“It’s losses throughout the tax base,” Mr Anthony told the Herald. “The Tax Office reckon they’ve reached 24 per cent of GDP. Usually they are 6 to 8 per cent of GDP. These are losses spread amongst individuals, super funds, trusts and companies, and they include capital losses in place of capital gains.”

“Along with declining terms of trade, a weaker than expected economy and mining industry depreciation expenses in place of taxable profits, it has put a spanner in the works.”

The Macroeconomics model projects structural budget deficits for the next decade and continued growth in government debt unless very big cuts are made tuesday week and spending growth is kept tight for the rest of the forward estimates.

“The Treasurer needs to cut $10 billion to deliver a surplus and $15 billion to deliver a structural surplus,” Mr Anthony said. “Otherwise there will be no sustainable return to surplus this decade".

Mr Anthony said government commitments were making Mr Swan’s job harder...

“Lifting the superannuation guarantee to 12 per cent will see the cost of the concession rise as the value of superannuation assets climbs. Yet the supposed funding comes from the mining tax which will diminish in GDP terms when the boom ends. The gap between the two could reach $5 to $7 billion by 2019-20.”

A list of suggested budget cuts included in the report is headed by “middle and upper class welfare”. “We suggest spreading the pain of adjustment as thinly as possible and imposing the largest burden on those likely to benefit from an upswing in the business cycle,” the report says.

“The idea is not to abolish programs but to target them to individuals on the basis of
hardship rather than electoral success.”

“Large savings can also be achieved through the widespread adoption of competitive
tendering processes, and incorporating economic efficiency principles into contract design especially for the purchase of large capital items, public works and defence weapons platforms.”

Macroeconomics predicts a boost in economic growth to a “respectable” 3.1 per cent in 2012-13, slowing to 2 per cent by 2015-16 as mining investment falls away.

In today's Sydney Morning Herald and Age

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Thursday, April 26, 2012

Want $8 billion in savings? Attack welfare for the well-off

Abolishing the Education Tax Rebate, the Medial Expenses Tax Offset and and tax rebates for private health insurance “extras” are among $8 billion of budget savings to be offered to the Treasurer today to help him make his budget surplus.

The Australian Council of Social Service says the list should also appeal to the Coalition, whose Treasury spokesman Joe Hockey has spoken out against tax concessions for trusts and the culture of entitlement.

“We do not think the budget surplus is a desirable goal in itself, but the push for a surplus does provide the opportunity to focus on measures that improve fairness,” said ACOSS chief executive Cassandra Goldie.

The $8 billion list, in a document entitled Waste not, want not: Making room in the Budget for essential servicesattacks a culture of entitlement that has grown up around health services.

ACOSS would remove from the private health insurance rebate cover for dental, optometry , physiotherapy and chiropractic services, saving $1.1 billion per year. It says high income owners are far more likely to insure for these treatments and claim the rebate. It would abolish the Extended Medicare Safety Net, most of which it says go to the top 20 per cent of families living in Australia’s wealthiest areas, saving $500,000 million...

It would save another $1 billion per year scrapping the Education Tax Rebate promised in the election that swept Kevin Rudd to power in 2007 and extended by Julia Gillard during the 2010 election campaign. Around $300 million would be saved ending concessional taatment for so-called golden handshake redundancy payments. Another $1.3 billion would be saved restricting the senior Australians tax offsets to pensioners. Tighter tax treatment of family trusts would save a further $1 billion.

“It’s a bipartisan list. Both sides have introduced measures on it and both sides say they oppose a culture of entitlement. It won’t make everyone happy but if it is explained well it can get support and help fund new spending on things we do need, such as national disability insurance,” said Dr Goldie.

Waste Not Want Not_ACOSS



17 APRlL 2012, LONDON


I wish to thank my friends at the Institute of Economic Affairs for the opportunity to discuss an issue that has been the source of much debate in this forum for sometime….that is, the end of an era of popular universal entitlement.

There is nothing much new in the debate other than the fact that action has now been forced on governments as a result of the recent financial crisis. Years of warnings have been ignored but the reality can no longer be avoided.

Despite an ageing population and a higher standard of living than that enjoyed by our children, western democracies in particular have been reluctant to wind back universal access to payments and entitlements from the state.

As we have already witnessed, it is not popular to take entitlements away from millions of voters in countries with frequent elections.

It is ironic that the entitlement system seems to be most obvious and prevalent in some of the most democratic societies. Most undemocratic nations are simply unable to afford the largesse of universal entitlement systems.

So, ultimately the fiscal impact of popular programs must be brought to account no matter what the political values of the government are or how popular a spending program may be.

Let me put it to you this way: The Age of Entitlement is over.

We should not take this as cause for despair. It is our market based economies which have forced this change on unwilling participants.

What we have seen is that the market is mandating policy changes that common sense and years of lectures from small government advocates have failed to achieve.

And we have subsequently witnessed over the last twelve months a raging battle. This has been a battle between the fiscal reality of paying for what you spend, set against the expectation of majority public opinion that each generation will receive the same or increased support from the state than their forebears.

The entitlements bestowed on tens of millions of people by successive governments, fuelled by short-term electoral cycles and the politics of outbidding your opponents is, in essence, undermining our ability to ensure democracy, fair representation and economic sustainability for future generations.

Perhaps we could re-apply noted British philosopher, AC Grayling’s words on liberty to our debate by declaring that we may record that the age of entitlement might have passed its best point, “after so brief a period of flourishing…”

And flourish it did.

Government spending on a range of social programs including education, health, housing, subsidised transport, social safety nets and retirement benefits has reached extraordinary levels as a percentage of GDP.

However an inadequate level of revenue has forced nations into levels of indebtedness that, in an age of slowing growth and ageing population, are simply unsustainable.

The social contract between government and its citizens needs to be urgently and significantly redefined. The reality is that we cannot have greater government services and more government involvement in our lives coupled with significantly lower taxation.

As a community we need to redefine the responsibility of government and its citizens to provide for themselves, both during their working lives and into retirement.

As part of this process, we must emphasise that government spending should be funded from revenue rather than by borrowing from future generations in whatever form that may take.

The Problem

Entitlement is a concept that corrodes the very heart of the process of free enterprise that drives our economies.

All of us would agree that there are some basic community entitlements. For generations we have all sought to define those basic rights.

For example, in the United States constitution the founding fathers determined that citizens are entitled to life, liberty and the pursuit of happiness.

You will remember it was Margaret Thatcher who interpreted community entitlements as the right for our children to “grow tall and some taller than others if they have the ability in them to do so”.1

This broader and timeless conservative definition of our end game lays down some foundations for the role of government.

Equality of opportunity rather than equality of outcome is my preferred model for contemporary society.

Thankfully the modern capitalist economy is centred around the satisfaction of personal wants and needs. Commercial transactions are at the core of the system. And it is a simple and proven formula for willing buyers to engage with willing sellers. If we want a product or service we go and buy it with the dividend from the fruits of our own labour. The producer is happy and the customer is satisfied.

The problem arises however when there is a belief that one person has a right to a good or service that someone else will pay for. It is this sense of entitlement that afflicts not only individuals but also entire societies. And governments are to blame for portraying taxpayer’s money as something removed from the labour of another person.

In our collective effort to win votes, political leaders deliberately portray a new spending commitment as if it is coming out of their own personal bank account. Political leaders rarely thank taxpayers for their funding of the policy.

To pay for all these good policy initiatives, governments have taken the easy option and borrowed money from that mysterious and amorphous group defined as “bondholders”.

We all know this is simply a case of borrowing money from the taxpayers of tomorrow for spending initiatives of today. Of course I say with irony, it gets even better when some governments borrow more money to pay the interest on current debt so existing taxpayers and voters will never notice the pain. This is the public sector equivalent of those much maligned ponzi schemes.

The sovereign debt problems we are seeing in Europe and the US today are the outcome of countries wanting a lifestyle they cannot afford but are quite happy to borrow from others to pay for.

Of course in recent months in some countries in Europe the “borrowings” have turned into permanent transfers of wealth as those countries have become unable – or unwilling – to repay the loans.

Richer countries are either writing off the debt of poorer countries or they are subsidising the debt repayments with sophisticated transfer payments.

As a parent I want to give my children everything they wish for.

As a democratically elected legislator I want to give my constituents everything they wish for.

The hardest task in life is to say NO to someone you care about.

So perhaps what we are witnessing is a chronic failure of the democratic process.

A weak government tends to give its citizens everything they wish for. A strong government has the will to say NO!

Being profligate is easy and politically popular in the short term, particularly when the political cost of raising sufficient revenue is avoided by resorting to debt.

But painless revenue makes for reckless spending.

Whether it is defence, law and order, income support, social programs and so on, the outcome is the same. Eventually the piper has to be paid.

Since World War 2 western communities have enjoyed prosperity that has exceeded all expectations. This has been fuelled by innovation, materialism, globalisation, free trade and debt.

Of course these are not malevolent developments. Rather they are the lauded natural outcomes of a free and successful society.

Moreover these initiatives, which have fuelled a massive improvement in global economic productivity, have driven the age of prosperity. Arguably this has delivered the most dramatic improvement in the material quality of life since the beginning of humanity.

In effect the rapid rise in private prosperity has been matched with demands for an equal improvement in state provided prosperity.

This is understandable. We all want the best available health care, the best education, the best pharmaceuticals and so on.

The difference is that the handbrake on private demand is income.

Unless a consumer can borrow money, it is their income and wealth which determines whether they can buy a new television or renovate the family home.

But for governments with seemingly unlimited capacity to borrow money, that handbrake on expenditure is not real.

While the Keynesian model of Government-led stimulus during the inevitable downturns in the economic cycle is well documented, governments who have turned on the fiscal tap seem completely incapable of turning it off when the cycle turns upwards.

So we have witnessed a continual over-commitment in many countries, funded by the lure of cheap and easily obtainable debt.

It is a problem which is not new. We might think by now we would have learnt the lessons. But clearly that is not the case.

A Tale of Two Systems

In September last year I travelled to Hong Kong – a city of 7 million2 - which sits at the edge of the Pearl River Delta - home to over 100 million additional residents. As a Special Administrative Region, Hong Kong is now serving as a conduit between China and its global trading partners, particularly those with business directly to the north.

So even though its destiny has changed, Hong Kong continues to maintain its own currency, laws and Parliament but is now totally wed at the hip to Beijing.

Without a social safety net, Hong Kong offers its citizens a top personal income tax rate of 17% and corporate tax rates of 16.5%. Unemployment is a low 3.4%3, inflation 4.7%4 and the growth rate still respectable at over 4%5. Government debt is moderate6 and although there is still poverty, the family unit is very much intact and social welfare is largely unknown.

The system there is that you work hard, your parents look after the kids, you look after your grandkids and you save as you work for 40 years to fund your retirement. The society is focused on making sure people can look after themselves well into old age.

The concept of filial piety, from the Confucian classic Xiao Jing, is thriving today right across Asia. It is also the very best and most enduring guide for community and social infrastructure.

The Hong Kong experience is not unusual in Asia. Characteristics such as low inflation, low unemployment, modest government debt, minimal unfunded benefits and entitlements, and significant growth are powering a whole range of emerging markets and developing an Asian middle class that will grow to some two and a half billion people by 20307.

The sense of government entitlement in these countries is low. You get what you work for. Your tax payments are not excessive and there is an enormous incentive to work harder and earn more if you want to.

By western standards this highly constrained public safety net may, at times, seem brutal. But it works and it is financially sustainable.

Contrast this with what we find in Europe, the UK and the USA.

All of them have enormous entitlement systems spanning education, health, income support, retirement benefits, unemployment benefits and so on. Some countries are more generous than others and in many instances the recipients of the largest amount of unfunded entitlements are former employees of the Government.

In all these areas people are enjoying benefits which are not paid for by them, but paid for by someone else – either the taxes of those who are working and producing income, or future generations who are going to be left to pay the debt used to pay for these services.

Despite tax rates much higher than in Hong Kong, government revenue in these economies still falls well short of meeting current government spending initiatives.

The difference is made up by the public sector borrowing money. And more often than not we are borrowing money from people such as the citizens of Hong Kong.

You would have to say that this is a flawed formula. For western democracies the party is over.

Our most deeply exposed western economies can no longer continue to accumulate debt without constraint. The ongoing credit crisis in Europe seems a very long way from resolution. Ultimately, spending on entitlements becomes a structural problem for fiscal policy.

In the United States for example, the excess of government expenditure over receipts is enormous. The Government has $15 trillion of Federal gross debt and it’s going up by $1.5 trillion a year because expenditure is $6.2 trillion a year and receipts $4.8 trillion8. Obviously with interest rates at near zero levels the cost of debt is limited but sooner or later it must end in tears.

So why is it that western nations are so deeply indebted and so tragically unfunded when it comes to meeting their future obligations in the face of an ageing demographic and longer life expectancies?

Both sides of the western political spectrum are to blame.

As the electoral pendulum has swung between socialist and conservative sides of politics, the socialist governments, often winning electoral success thanks to the funding from unions, have created a huge array of entitlements for selected classes of individuals, particularly and ironically employees of government and members of unions.

These entitlements have now begun to hang like a millstone around the neck of governments, mortgaging the economic future of many Western nations and their enterprises for generations to come.

I will give you a classic example. In Boston USA, there’s a certain former police captain who retired aged 55 some 20 years ago after a 32 year career on the force. During that period he managed to contribute some $73,000 to his defined benefit pension plan, a plan which gives you a percentage of your salary for life when you retire. On retirement he started receiving 100% of his retirement salary, namely $55,000.

He is now 75, which means he has collected some $1.1 million in benefits. And it looks like he’ll live until he’s at least 90 or even older, so that’s almost another $1.0 million over 15 years. It’s more than he earned in 32 years and he contributed just $73,000 to help pay for it. Either taxpayers pay the bill or the government has to borrow to pay for the entitlement.

When the electoral pendulum swings, conservative governments have come in promising to fix the problem but in most instances have just trimmed around the edges without addressing the real problem of the growing entitlement burden.

And the greatest Catch 22 of modern democratic politics is that socialist governments are blindly wedded to increases in expenditure while conservative governments are blindly wedded to not increasing taxes. So once the cycle of economic growth comes to its inevitable end, the problem is exacerbated.

Perhaps the real problem is the exuberant excesses of politicians who do not seem to understand or care about the fact that like a household, a nation needs to balance its budget over time and needs to make sure it can cover its future commitments.

This has already reached dangerous levels with some OECD countries like France spending close to 30% of their GDP on public social expenditure.

Other countries get by with much less. Korea only spends 10% of GDP on public social expenditure with Australia at 16% of GDP, the USA at 20% and the United Kingdom at 23%.9

The bottom line is that our communities need to make a tough decision. We cannot choose both higher entitlements and lower taxes. We must make a decision one way or the other. We can take more and more of our citizen’s money and spend it for them, or we can take less of it and rationalise government services.

But it is a decision that must be made …and soon.

This challenge is compounding in scale as an ageing population in many industrialised countries is making even further demands on the entitlement system.

Europe for example, has the highest proportion of over 60s of any region in the world. And while 22% of the population in Europe is currently over 60, this number is forecast to rise to 35% by 2050.

Plans for the future of Europe have assumed strong economic growth, but it is highly uncertain how growth will be achieved as the fiscal burden associated with rising health and aged care costs, as well as a generous pension scheme, continues to grow.

According to a study commissioned by the European Central Bank10, 19 EU countries had almost 30 trillion Euros of unfunded entitlement obligations for their existing populations. Of this 30 trillion Euros, France has liabilities of 6.7 trillion and Germany 7.6 trillion.

These liabilities will continue to grow without significant reform. And, by the way, I don’t see how a debate in France about lowering the retirement age from 62 to 60 will help address these challenges.

A lower level of entitlement means countries are free to allow business and individuals to be successful. It reduces taxation, meaning individuals spend less of their time working for the state, and more of their time working for themselves and their family.

An economy that impedes individual ambition - whether through higher taxation, the lack of opportunity in employment, or restricted social mobility - is one that enforces the barriers of class, rather than reduces them.

Governments should ensure that the actions they take will leave their citizens better off because, naturally, that will reduce the desire for ‘entitlements’. The role of government must be to help people to the starting line, while accepting that some will then run faster than others.

Everyone should know that they grow up in a country where it is possible, through hard work and diligence, to achieve their dreams.

Naturally the Americans call this the American Dream, but it is similarly played out across the globe, including in emerging economies in Asia.

The Australian Experience

As the child of a father who came to Australia in 1948 as a refugee from Palestine and built himself into a successful businessman, I know that being successful in Australia is not the product of belonging to rich and prosperous families, but rather is the result of hard work and diligence.

In fact those stories are most often repeated in countries without extreme interventionist governments. For example, over 80 per cent of the millionaires in the United States are the first generation in their family to be millionaires.

But Australia has had its fair share of irresponsible governments. In 1996 the incoming conservative government inherited a budget in a weakened state. The previous Labor administration had racked up a succession of budget deficits and $96bn of net debt, about 17% of GDP. (I know that figure is not large by the current experience of most countries in Europe, but trust me, the repayment task was a challenge.)

It took nine years of budget surpluses and asset sales to repay the debt. That is three election cycles in Australia.

It took another two years of hard fiscal rectitude to build up a stock of net assets equivalent to 4% of GDP. In total that is a long period of sustained fiscal austerity.

Australia has not completely avoided the problems of other western democracies because it still has a lot of spending by government which many voters see as their entitlement.

However, over the years there have been a number of key decisions to reduce spending to manageable levels.

Australia has sought to reduce the burden on government of providing aged pensions through a compulsory system of savings for retirement. Retirees must rely first on the benefits they have accumulated rather than on government income support. And retirement benefits to government employees and politicians are no longer provided on a defined benefit basis but on a contributions basis so they only get back the principal and earnings on what they have put in.

The government is also gradually raising the age at which government benefits can be accessed, from 60 to 67 for women and from 65 to 67 for men from 1 July 2023.

Most importantly, the net government assets of $45 billion arduously built up by the previous conservative government were set aside into a Future Fund. The funds cannot be touched by the government for everyday expenditure. Rather, the fund can only be accessed to pay for the previously unfunded entitlements of federal public servants so as to reduce the burden on taxpayers.

That was an initiative of great foresight. It is, if you like, Australia’s sovereign wealth fund with the explicit purpose of boosting the sustainability of the budget through time.

The Road Back

So where do we go from here?

There is really only one solution in the long term, and that is for countries to live within their means.

We must rebuild fiscal discipline. Budget surpluses must be restored, ideally until the debt is repaid.

This can only be achieved by cutting spending or by raising taxes. And given the general acceptance that the increased drag from higher taxes would compromise economic growth, the clear mandate is to lower expenditure.

This is lovely rhetoric but to actually do it needs some very harsh political and social decisions.

To be bold, I have some suggestions.

The first is that people need to work longer before they access retirement benefits. When the age pension was introduced in Australia at age 65, life expectancy was 55. Today life expectancy is in the 80’s.

So you can understand how I was shocked to hear that one of the policy promises of one of the main French Presidential Election candidates, Fran├žois Hollande, is to bring the official retirement age back down to 60 from 62.

Second, there have to be universal compulsory retirement schemes into which employees and employers must contribute so that after a man or woman has worked for 40 or more years they have set aside an amount that can provide them with a reasonable income for a further 15-20 years at least.

Defined benefit schemes need to be phased out worldwide, including in Australia, whether they are for public servants or private sector employees. In addition, all government funded pensions and other such payments must be means tested so that people who do not need them do not get them.

Third, there needs to be clear thinking about which services should be provided by governments and whether government funded services should be entirely free or have some affordable co payment. Many will argue that certain government services should be free and universal but the problem with any free good is that it will be overconsumed and underappreciated.

For example, in Australia, health services are partly funded through compulsory levies, paid either to the government or to private health insurers.

Across the Western world we have saddled our nations and our children with a debt burden that is simply unsustainable. It is time for strong political and economic leadership to clean up this mess properly, not with a series of band aids and political spin but with genuine economic and social reform.

The age of unlimited and unfunded entitlement to government services and income support is over. It’s as over in Greece as it is in Italy, in Spain, and in the USA.

There also needs to be a rethinking of government borrowing. Some might argue that some low level of debt is not a bad thing. I believe that is a dangerous proposition. Once some level of debt is accepted it becomes too tempting to opt for just a little more. Pretty soon a little debt becomes a big problem.

Also, there is a significant cost to servicing debt. Even in Australia, where net debt as a percentage of GDP is lower than in Europe, interest costs on net debt are approaching $7 billion a year. That is enough to build 7 new teaching hospitals every year.

The message is that every dollar of debt has an opportunity cost.

Another aspect of the problem is that credit is no longer easily accessible for the private sector or the public sector.

And the credit market no longer automatically favours the public sector. Ironically more and more sovereigns are seen as a greater credit risk than many international companies. I would think the experience of the past few years has been something of a reality check. Lenders now know that even today advanced western economies can default on their debts.

In today’s global financial system it is the financial markets, both domestic and international, which impose fiscal discipline on countries. A country which is viewed as approaching its safe limit for debt will find it increasingly difficult to borrow additional funds at an affordable rate. Eventually the capital markets will close.

We are now in an era where lenders are much more wary about credit risk. I view this as a healthy development.

Lenders have a more active role to play in policing public policy and ensuring that countries do not exceed their capacity to service and repay debt.

This is playing out most dramatically in Europe where the European Commission and the European Central Bank are either directly or indirectly heavily influencing public policy in Greece, Italy, Spain and Portugal to name a few.

It is also worth noting that the system of regulation of banks and other deposit taking institutions is artificially boosting demand for sovereign credits with mandated liquidity requirements generally emphasising a prominent role for government securities.

Governments have been too prepared to exploit the resultant lower borrowing costs.

And whilst securities issued by sovereigns have traditionally been viewed as the safest and most liquid assets, I am not sure that it is still the view of investors in Europe today.

Concluding Comments

The road back to fiscal sustainability will not be easy.

It will involve reducing the provision of so called “free” government services to those who feel they are entitled to receive them.

It will involve reducing government spending to be lower than government revenue for a long time.

It is likely to result in a lowering of the standard of living for whole societies as they learn to live within their means.

The political challenge will be to convince the electorate of the need for fiscal pain and to ensure that the burden is equally shared.

Already in the UK and parts of Europe we have seen the social unrest that can result when fiscal austerity bites.

But the alternative is unthinkable.

The Western world cannot continue on its current path of borrowing to fund its excessive lifestyle. The problem of fiscal sustainability will only get worse.

Eventually lenders will cry enough is enough and turn off the credit tap. And when that happens the economic, financial, social and political dislocations are likely to be catastrophic.

The Western world is at the most important economic cross road in its history - Governments must accept their responsibilities to fiscal discipline and the prudent use of their citizens hard earned monies, or they need to accept that the demise of western economies will be forced upon them in a dramatic, unpredictable and possibly violent way.

Adam Smith’s free hand is perfectly capable of forming a fist to punish nations who ignore the fundamental rules. Unfortunately I think Adam’s down at the gym right now and in training for one almighty whack.

Restoring fiscal credibility will be hard. But it is essential we learn to live within our means.

The Age of Entitlement should never have been allowed to become a fiscal nightmare. But now that it has, Governments around the world must reign in their excesses and learn to live within their means. All of our futures depend on it.

[1] Speech to the Institute of Socio Economic Studies “Let Our Children Grow Tall” September 15, 1975

[2] World Bank

[3] February 2012

[4] ibid

[5] GDP year to Q3 2011

[6]Gross debt of 33.8% GDP in 2011, IMF World Economic Outlook Database, September 2011

[7] Can the Asian Middle Class Come of Age?, Homi Kharas, The Brookings Institution, 12 June 2011

[8] IMF, World Economic Outlook, September 2011

[9] OECD Social Expenditure Database, estimates for 2012

[10] Pension obligations of government employer pension schemes and social security pension schemes established in EU countries, Final Report, European Central Bank, January 2009

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Wednesday, April 25, 2012

Getting inflation wrong

Nine months ago Alan Kohler labelled the June quarter inflation figures "a disaster".

"The June quarter consumer price index is a disaster. It means the “cautious consumer” that Glenn Stevens was talking about on Tuesday and the high Australian dollar have not turned into lower inflation; the disinflation from the GFC is finished and Australia’s dreadful performance on productivity over the past decade is being brutally exposed. The RBA will now have to whack us all over the head with the blunt instrument known as interest rates."

He was wrong, but he wasn't alone.

Only a few voices looked inside the figures and saw something much less worrying than on the surface.

I was one of the first.

"Take a deep breath. Inflation is not, as one commentator opined this week, “a disaster”. It seems to me to be a long way short of what would be needed to bring forward an interest rate hike Tuesday, as the ANZ is now predicting. There’s no doubt the headline figures are high... But there are good reasons not to place too much weight on any of these figures, and the Bureau knows it.

From next quarter the Bureau will publish a new improved consumer price index, removing one of the most erratic and troublesome components and shunting it off to an appendix. The so-called “deposit and loan index” is a valiant attempt to measure what banks charge... ecause the estimate is a derived number based on all sorts of assumptions it bounces around wildly, at times it turns negative....

Higher fruit prices accounted for an astounding 39 per cent of the increase in the CPI. They won’t last. It’s easy to see that by looking at what happened to the price of vegetables. They shot up 16 per cent in the March quarter after the floods, and then slid back 10 per cent as crops regrew. Fruit trees take longer to regrow than vegetables, but they do regrow. Not only will the upward pressure from higher fruit prices soon leave the CPI, it’ll soon be replaced by downward pressure as fruit prices return to earth.

You might think none of this should affect the Reserve Bank’s two underlying measures of inflation, the ones that came in at 0.9 per cent you might think. You would be wrong..."

All sorts of people rubbished my reasoning, Christopher Joye among them:

"These claims are wrong for two reasons. First, as I have explained before, deposit and loan charges have almost no impact on the "weighted median" inflation measure (which is simply the 50th percentile inflation rate and not affected by outliers like the trimmed mean can be). Second, RBS's Kieran Davies and Felicity Emmett have shown that even if you exclude this variable from the trimmed mean (or "average" core inflation)--which is a questionable decision--underlying inflation over the last half year is still running above the top of the RBA's target 2-3% per annum band."

He was one of the kind ones.

Fortunately (for us all) Tim Colebatch picked up the scent, pointing to further problems with the CPI:

"The weightings given to items in the CPI are based on an old survey of household spending. But the Australian Bureau of Statistics changes them to reflect price rises and falls, assuming that we keep buying the same quantities of goods regardless of price changes. That defies reality, and over time, creates a bias that overstates the inflation rate, as the index increases the weight of items that rise in price, and decreases the weight of items with falling prices...

Take bananas and computers. When this series began in 2005, fruit and vegetables comprised 2.1 per cent of our spending, and computers 1.5 per cent. But fruit and vegetable prices have soared since cyclone Yasi, while computers now pack far more power than in 2005.

But the bureau assumes we still buy just as many bananas, even at $12 a kilo, and buy 2005-strength PCs very cheap. So the CPI is estimated on the basis that fruit and vegetables now comprise 3 per cent of our spending, and computers just 0.5 per cent. And that is wrong."

Bit by bit it became clear that both the official and underlying figures had indeed been overstated. It's now accepted wisdom.

Instead of raising rates the Reserve Bank cut them twice and is about to cut them a third time, then probably a forth.

All but a handful got inflation wrong.

Related Posts

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. Where were we? What's wrong with the CPI

. Inflation is not what it was - that's official


CPI weak. Why the Bank will cut, then cut again

Australia is in for a new round of rate cuts, beginning with a cut of at least 0.25 points at the Reserve Bank board meeting next Tuesday followed by extra cuts to boost the economy in the wake of a contractionary May budget.

Debate at Tuesday’s meeting will be about whether to cut the cash rate 0.25 or 0.50 points after much weaker than expected inflation figures showed very little price pressure in the economy away from utilities and services such as childcare and health.

The consumer price index climbed just 0.1 per cent in the first three months of year, and by just 1.6 per cent over the year to March - the weakest annual price growth since the 2009 global financial crisis.

Weighing down prices was a 60 per cent drop in the price of bananas in the quarter and a 30 per cent side in the price of fruit. Over the year to March fruit prices fell 24 per cent and vegetable prices 17 per cent.

Even ignoring the price of volatile items such as fruit and vegetables inflation is weak. The Reserve Bank’s measure of so-called underlying inflation came in at an extraordinarily low 0.35 per cent for the quarter and 2.15 per cent for the year. The annual figure is the lowest in 13 years.

“The Reserve Bank got it wrong,” said Stephen Koukoulas, an economic consultant who was until recently an advisor to prime minister Gillard. “They should have cut in February, they should have cut in April. Even as late as last year they were expecting inflation above 3 per cent. It is now clear they underestimated the impact of the strong dollar and failed to appreciate how weak retailing and construction really were.

“This is not a harsh criticism. Every error the Reserve Bank has made in the past it has corrected. There is nothing embarrassing about reversing course. The Bank will cut by at least 0.25 points Tuesday and possibly 0.50 points. I think they should cut by 0.50 to offset some of some of the rate hikes imposed by retail banks"...

Treasurer Wayne Swan said while the Reserve Bank was independent “you would only have to look at their minutes published a week or two ago to see that they themselves have said that they'll be looking closely at this inflation number, and they will do that and take their decision independently”.

The Bank said if inflation eased further “a case could be made for a further easing of monetary policy”.

The recommendation to be sent to board members this week will be for a rate cut. Governor Glenn Stevens will open the meeting up for discussion about the size of the cut. Further cuts will be needed if private banks fail to pass on all of the cuts or if the May Budget dampens the economy as is expected.

Financial markets were last night pricing in four more cuts of 0.25 per cent by Melbourne Cup day, taking the Reserve Bank cash rate down from 4.25 per cent to 3.25 per cent. If fully passed on they would bring down standard variable mortgage rates from around 7.4 per cent to 6.4 per cent, cutting $190 per month from the cost of servicing a $300,000 mortgage taking the monthly total below $2000.

Attempts to make political capital of the Reserve Bank’s deliberations turned to farce yesterday when opposition leader Tony Abbott wondered out loud whether the Bank would “lover interest rates today”, apparently unaware the Bank board wasn’t meeting until next Tuesday. Financial services minister Bill Shorten pounced, saying anyone who wanted to be the alternative prime minister ought to know when the Bank board met.

“The Reserve Bank board has been meeting on the second Tuesday of the month since 1960,” he told the ABC’s PM program. Mr Shorten was also wrong. The board meets on the first Tuesday of the month.

The inflation figures show prices for necessities increasing strongly. Electricity prices climbed 9.9 per cent during the year, childcare prices 9.7 per cent and petrol prices 5.9 per cent. The price slides were more likely to be in optional purchases. International travel was down in price 3.1 per cent, women’s clothes 2.8 per cent, computers and electronics 9.7 per cent and CDs, DVDs and computer software 18 per cent.

In today's Sydney Morning Herald and Age

COLEBATCH: "The Reserve made a mess of it. It kept overestimating growth. It kept overestimating inflation. It raised interest rates far too high, and has kept them too high. It has no more excuses. It must now fix the problems it created."


Electricity + 9.9%
Childcare + 9.7%
Water and sewerage + 9.3%
Insurance + 7.3%
Tobacco + 6.3%
Public transport + 6.2%
Education + 6%
Medical & dental + 5.9%
Petrol + 5.9%
Domestic travel + 5.4%
Telecommunications + 4.5%
Rents + 4.4%
Beer + 3.4%

Men’s clothes - 1.4%
Women’s clothes - 2.8%
Motor vehicles - 2.8%
Milk - 4%
International travel - 3.1%
Computers and electronics - 9.7%
Vegetables - 17.1%
CDs, DVDs and software - 18%
Fruit - 24%

ABS 6401.0 Consumer prices, year to March

Related Posts

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. Attention Reserve Bank: Inflation is not as bad as it looks

. At last, the RBA gets off its hands. Why it's May 1


Tuesday, April 24, 2012

Newstart is so low we don't think we could live on it

How much does a single adult need to live on? According to a survey of 500 Australians conducted for the Australia Institute the average answer is $454 per week; around $65 per day.

When a separate 500 were asked how much unemployed Australians should get from Centrelink they settled on $329 per week - $47 per day.

But the less-impressive truth is the Newstart allowance peaks at $245 per week - $34.70 per day.

“Most Australians have little idea what unemployed Australians actually get,” said Australia Institute executive director Richard Denniss releasing the results.

“They know what their own cost of living is and the think unemployed Australians should get something approaching it, but they would be shocked to find out what a Newstart recipient actually got.”

The $84 per week gap between Newstart itself and what Australians believe it should be exceeds the $50 per week increase proposed by a coalition of business, welfare and union organisations led by the Australian Council of Social Service. ACOSS says the increase would cost $1.2 billion per year.

Asked what they would cut back on if they were forced to live on $243 per week 88 per cent of those surveyed said they would drive their car less, 77 per cent said they would use less electricity and gas for heating... and 63 per cent said they would buy less fresh food.

“More disturbing are the findings 47 per cent would cut back on education and training and 45 per cent would cut back on visits to the doctor,” said Dr Denniss. “Poor health and poor education make it hard to get off Newstart and hard to get good jobs.

A separate study by the Tenants Union of Victoria has found the single Newstart allowance now barely meets the median rent in Melbourne and Perth and falls well short of the median rent in Sydney.

Treasurer Wayne Swan has acknowledged the problem but ruled out boosting the $34.70 per day allowance in the May budget.

Dr Denniss said there was ample room to cut concessions to high-income superannuants and subsidies for mining if the Treasurer really wanted to boost Newstart.

In today's Sydney Morning Herald

Are Unemployment Benefits Adequate in Australia

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Monday, April 23, 2012

We're an open book. Our costs are going up - ANZ

The ANZ has hit back at claims it is gouging by lifting mortgage rates independently of the Reserve Bank saying its monthly adjustments are to recover costs and not to widen margins.

In an article published in the Herald today the chief executive of ANZ Australia Philip Chronican says the bank’s wholesale funding costs increased in all but one of the past six months.

“As less expensive funding (costing on average 72 basis points above the three month bank bill swap rate) matured and was replaced with more expensive funding (on average 165 basis points above) reflecting the current conditions in global markets, ANZ’s average cost for term wholesale funding increased by 15 basis points,” Mr Chronican says.

The relative cost of deposits climbed even more as the gap between the Reserve Bank cash rate the average amount the ANZ paid depositors climbed by 28 points.

A spokesman for Treasurer Wayne Swan was unimpressed, pointing to this month’s Reserve Bank board minutes which said wholesale funding costs had eased in recent months.

Speaking to the ABC from Washington where he has been attending a G20 finance minister’s meeting Mr Swan referred to “debacle” of the Coalition defending the ANZ rate hike.

The ANZ has lifted rates twice out of step with the Reserve Bank in recent months, by 6 points in February and a further 6 points in April.

Its competitors have lifted rates by between 9 and 15 points. It says although it has lifted rates more slowly its mortgage and small business rates “remain in line” with its competitors.

“We accept the decisions we make in an environment where funding costs are rising are not popular or easy, and in an uncertain economic environment many people have strong views about these decisions,” Mr Mr Chronican writes. “It is however difficult to have an informed public debate about these issues when people of influence in the community are not aware of key facts or are willing to misrepresent them.”

In Washington Mr Swan announced the commitment of a further $7 billion to the International Monetary Fund to assist countries in financial trouble. He said if called upon the loan would be repaid with interest.

In today's Sydney Morning Herald and Age

Integrity and transparency on bank funding costs

Philip Chronican, CEO, ANZ Australia

ANZ’s decision to set variable interest rates for mortgage and small business lending on a
monthly basis has sparked a great deal of debate in recent months. At a time many people
are feeling uncertain and worried about the global economy and their future, these views
are understandable and they reinforce the significant responsibilities that banks have when
making commercial decisions.

While nothing is likely to remove the anger many people feel about decisions on interest
rates, banks like ANZ are serious-minded institutions and they make decisions based on a
strong factual basis. While some challenge this, it is not possible to be in business for 177
years, serve eight million customers and provide almost $600 billion in lending if you are not.

In recent days, questions have been raised over whether ANZ could justify the increase in
mortgage and small business lending rates of 6 basis points (0.06 per cent) that it announced
on 13 April.

First, it is useful to point out that following ANZ’s earlier decision in February to increase
interest rates by 6 basis points other Australian banks increased their interest rates by
between 9 and 15 basis points. ANZ’s cumulative increase of 12 basis points has meant that
although it has increased rates more slowly, its mortgage and small business lending rates
remain in line with our competitors.

Although that may be reassuring for customers, it doesn’t answer the question as to whether
the increase was justified.

Much has been made of comments by the Reserve Bank of Australia on bank funding costs
in the minutes of its April monetary policy meeting issued on 17 April. The comments have
been used selectively by some to reflect particular perspectives and ANZ’s integrity has been
called into question.

Banks raise funds to lend to customers from two main sources – from customer deposits and
in wholesale markets from domestic and international investors.

In the six month period from 1 October 2011 to 31 March 2012, the average cost of ANZ’s
$75 billion stock of term wholesale funding increased every month, except in December 2011
when credit markets froze because of the European sovereign debt crisis and wholesale
markets were closed globally.

As less expensive funding (costing on average 72 basis points above the three month bank
bill swap rate) matured and was replaced with more expensive funding (on average 165 basis
points above) reflecting the current conditions in global markets, ANZ’s average cost for term
wholesale funding increased by 15 basis points from 116 basis points above the three month
bank bill swap rate to 131 basis points.

We accept that for most people this sounds complex however we believe it is important
that we are transparent on these additional costs. The Reserve Bank however highlighted
its understanding of the situation on 17 April when it said: “Corporate bond spreads had
narrowed further and where now significantly lower than at the beginning of the year, though
still higher than in the middle of 2011, particularly for banks.”

While much is made of wholesale funding, the primary source of lending is customer
deposits. In announcing the outcome of our monthly interest rate review in April, ANZ stated
that: “Increased competition for deposits, particularly term deposits, is currently the most
significant driver of rising funding costs.”

In the six months since 1 October 2011, the difference between the Reserve Bank’s overnight
cash rate and the average amount that ANZ pays to depositors has also risen, up 28 basis
points from 0.41 per cent to 0.69 per cent above the cash rate.

This was also highlighted by the Reserve Bank on 17 April: “As a consequence of banks
competing aggressively for term deposits, their cost had risen materially relative to the cash

The bottom line is that, taking into account ANZ’s funding mix of deposits and short and long
term wholesale funding, our funding costs are up 18 basis points over the past six months
while ANZ’s variable interest rates have risen by 12 basis points.

When ANZ moved to set interest rates on a monthly basis last year, we promised to be
more transparent about bank funding costs with a view to increasing understanding about
the commercial situation we faced. We did this as an institution that is serious about its
responsibility to balance shareholder needs against those of customers, the need to support
continued growth in the economy and the wider interests of the community.

We accept the decisions we make in an environment where funding costs are rising are not
popular or easy, and in an uncertain economic environment many people have strong views
about these decisions. It is however difficult to have an informed public debate about these
issues when people of influence in the community are not aware of key facts or are willing to
misrepresent them.

ANZ does make decisions with integrity and using a sound base of facts which we will
continue to share with our customers and with interested stakeholders including at our
forthcoming half year financial results which will be announced on 2 May.

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Friday, April 20, 2012

Wrong, wrong, wrong: Gillard, Hockey, Robb

What a week.


Her speech on the "economic" arguments for the surplus is not yet on the web. I'll put a link here when it is.

She says: "Friends, let me make this clear once and for all: a budget surplus is not a political target but a potent economic tool."

And then proceeds to elaborate (emphasis added):

"A budget surplus speaks of confidence in Australia’s creditworthiness and good economic management...

"So the best way we can demonstrate to global investors that we are a sound place to invest is by the strength and resilience of our economic institutions and policies.

No signal is more powerful than a strong and disciplined fiscal framework.

A budget surplus when the economy is growing also speaks powerfully to the Australian community about having a government that manages their money prudently.

Okay, okay - it's about public relations, not economics despite what you say. I never believed otherwise anyway.


He seems unaware of just how targeted Australian social spending is. Here, Matt Cowgill enlightens him. This graph tells the story as well as anything else:

Professor Peter Whiteford says “Australia actually has the lowest middle or upper class welfare in the OECD”. And he should know, he used to work in the OECD.

But one of the most targeted social support systems in the world isn't good enough for Mr Hockey, as he explained on LateLine:

TONY JONES: Okay, I'm only going to interrupt you there to allow you to expand on that because you give a very passionate defence in the speech of the system in Hong Kong, for example, where the top rate of personal income tax is 17 per cent, the top corporate rate is 16.5 per cent - the trade off there being that there's no social safety net, so, instead, people take care of their own families.

Would you - do you think that's a model that could be followed in Australia?

JOE HOCKEY: I wouldn't go so far as what Hong Kong is doing, but Hong Kong is our competition, Tony. This is the thing. If we talk about the Asian century in Australia, if the Government talks about the Asian century, then the Asian countries are our competition, our children's competition.

We can no longer compare ourselves with Europe and the United States, which have massive fiscal and structural problems. And I keep alluding to Hong Kong because Hong Kong is our direct competition, as is Singapore, as is Korea in different ways, Vietnam, Indonesia. They're our competition in many ways.

TONY JONES: OK. The logic of what you're saying is that you would quite like to see Australia move part the way in that direction - lower personal income taxes, much lower company taxes as well accompanied by a lowering of entitlements, which is the only way you could afford it really. Is that correct?

JOE HOCKEY: Well, in part. I mean, it's also the case that you've got to drive productivity growth and that's something that we've spent a lot of time talking about.

As I Tweeted during LateLine the following night:

You opposed means testing of the Private Health Insurance Rebate @JoeHockey #LateLine #auspol

You opposed means testing of the baby bonus @JoeHockey #LateLine #auspol

You said families taking in over $150K deserved government support @JoeHockey #LateLine #auspol

It's about as credible as the man who (mis)administered the Access Card coming over as a believer in privacy. Oh, he's done that too.


What compelled him to go on AM and implicitly back the ANZ's rate rise with trusting garbage such as this?

SAMANTHA HAWLEY: So is the ANZ bank justified?

ANDREW ROBB: Well I'd have to look at their books.

You know, they're not stupid and I don't think they would willy nilly put up their margin like this if they weren't - if they weren't suffering a problem with their margins.


ANDREW ROBB: You know, they're not - They are responsible citizens. Their books in the end will be on the table, their profit margins and all the rest, so...

SAMANTHA HAWLEY: The ANZ bank made a pretty decent profit didn't it, last year?

ANDREW ROBB: No, but it's the return on capital and things. I mean look at banks that are heavily part of superannuation funds - millions of Australians depend on the banks performing.

The ANZ's return on equity is 14.88 per cent. Talk about a culture of entitlement.

But Robb trusts them. Oh, and he wants to be Minister for Finance.

What a week.

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'Too much money was sloshing around' - Turnbull on Howard's economic mistakes

The guy is honest, gutzy, serious. Unlike his frontbench contemporaries

Coalition Communications spokesman Malcolm Turnbull has crashed into the economic debate, saying the Howard government made bad economic decisions in its final years, ones for which he accepts collective responsibility.

“The simple fact is, and we’ve seen it again and again in this city, when governments have money sloshing around they want either to spend it on benefits, invest it in infrastructure or give it back in tax cuts,” he told a Canberra forum organised by the Melbourne Institute.

“There’s nothing wrong with any of those objectives if the spending or the tax cutting for example is sustainable, well targeted, and represents value for money. But regrettably that isn’t always the case.”

Mr Turnbull believes the Coalition should have banked much more of the income from the mining boom, perhaps by putting it in a wealth fund managed by the Future Fund. But he said the idea had become less attractive after “the so-called Keating debt had been paid off.”

“I say this as somebody who has been part of a government and made collective decisions about spending. This is a behavioural economics perspective. From a political point of view my strong belief is that a new sovereign wealth fund would be very much in the spirit of the times, and would become a matter of real national pride.”

Asked which of the Howard government’s decisions were bad he said: “This isn’t the time or the place, nor would I be able to comprehensively chronicle them all, but I think most of us feel that, Peter Costello clearly does.”

“The reality was inevitably the surpluses came in - in those last three years much bigger than forecast - so the government was presented with a lot more money at the eleventh hour, as it were.”

Mr Turnbull’s observations challenge the Coalition’s formal position that it was its economic management that brought about its repeated budget surpluses...

He also took issue with those on both sides of politics who want the Reserve Bank to cut interest rate in order to restrain the Australian dollar. They include Coalition finance spokesman Andrew Robb and Australian Workers Union leader Paul Howes.

“To complain about the current level of the dollar is to implicitly oppose the current size of the resources sector,” he said.

“In a sense by developing an iron ore or a coal industry in the first place while while having a floating currency and free capital flows Australia signed on for the current ride.”

As an instance of what could happen when a government tried to restrain the exchange rate he singled out the McMahon Coalition government of 1971 and 1972.

“Arguably among the most costly policy miscalculations in our history was the Country Party’s repeated veto of the stronger dollar in 1971 and 1972, which stoked the runaway inflation which ultimately averaged 9 per cent annually for the next two decades - it took a long time to get over that.”

The Country Party was the National Party’s predecessor. Mr Turnbull’s analysis differs from that of other Coalition politicians who blame the two decades of high inflation that grew out of the 1970s on the succeeding Whitlam Labor government.

Former Reserve Bank board member Bob Gregory backed Mr Turnbull’s support for a sovereign wealth fund but said in his view interest rates were too high because the Bank had overestimated the strength of the economy. It would soon correct its mistake and cut rates.

In today's Canberra Times, Sydney Morning Herald and Age

Malcolm Turnbull writes:

Peter Martin’s article in the Sydney Morning Herald today rather misrepresents a very sober and fairly academic discussion about the exchange rate, fiscal discipline, the mining boom and sovereign wealth funds at the Melbourne Institute Conference in Canberra yesterday.

Speaking on the same platform as Professors Max Corden and Bob Gregory it wasn’t the occasion for a rip roaring partisan political harangue but rather a more thoughtful and considered analysis of some important political issues. It was certainly received that way.

My only comments on the Howard Government’s spending was to say that with the benefit of hindsight we could have saved more in our last years in office – that is hardly a novel observation, and as The Australian’s David Uren reports, I noted that it was significant that our side of politics, having governed Australia well and responsibly for nearly twelve years, is nonetheless prepared to reflect on how we might have done a good job even better.

What Peter Martin failed to report was that I pointed out that politics is a relative business and that compared to the reckless spending of the Rudd and Gillard Governments the Howard Government’s record was in terms of fiscal matters “stellar” – as indeed the record shows. John Howard not only paid off all of Labor’s debt, left us with a substantial cash at the bank but also established our first sovereign wealth fund, the Future Fund with the proceeds of asset sales and surpluses.

I might add there was no reporting of the strong criticism I made of the Rudd Government’s mishandling of the mining tax issue, both in terms of process and design.

Peter Martin asked me to nominate particular spending decisions I didn’t agree with and having declined to talk about one decision or another or otherwise go into particulars this is what I said:

“..most of us feel we could have saved more, certainly in the last term in particular. The reality was that surpluses came in invariably in the last three years much bigger than had been forecast. The Government was presented with a lot more money at the eleventh hour. Quite a lot was saved. Politics, just like interest rates, is relative. One thing that is commendable is that our side is having an honest reflection on whether – notwithstanding we did a very good job paying off debt, establishing the Future Fund and other funds and adding to national savings and (in this regard) compared to our successors did a stellar job, it is I think a good thing to be reflecting on whether that job could have been done better. I guess what I am saying is that if we had a – if there had been an ongoing sort of program of thrift and saving [referring to the sovereign wealth fund proposal] that would have been a good alternative, more money would have been saved.”

Now, quite how you can turn an answer like that into a headline which says “Coalition economics not on the money: Turnbull” let alone argue that my observations “challenge the Coalition’s formal position that it was its economic management that brought about its repeated budget surpluses.”

Quite the contrary is the case, the repeated budget surpluses were the result of sound economic management – they are the proof positive.

My point is that when surpluses are high Governments are under pressure either to spend them or give them back in tax cuts. As I said in my speech as long as the decisions to spend or cut taxes are sustainable, there should be no hesitation in doing so. But if those decisions taken at the top of the cycle create long term obligations or entitlements or create long term diminutions in the tax base which have the consequence of creating a structural deficit then they are not wise.

Now I do not believe the Howard Government did that, quite the contrary. But the Labor Governments that succeeded us have done just that, by overspending they have created the extraordinary situation where they have been borrowing record amounts and running deficits in the midst of the biggest terms of trade boom in our nation’s history.

So my argument for a new sovereign wealth fund, for creating a stronger culture of thrift and saving is that it will provide another option for governments faced with strong revenues – one of saving for the long term. And that is entirely consistent of course with the philosophy and the the practice of the Liberal Party in Government.

A high exchange rate - should we be concerned and what should be done?

Malcolm Turnbull
Melbourne Institute – Public Economics Forum
Canberra, 19 April 2012

Well thankyou very much. Let me start by saying that I’m very honoured to be in such illustrious company for this discussion.

Max Corden, my fellow speaker, is of course one of our nation’s most distinguished economists and his work on industry protection, trade and exchange rates has not only contributed to economics as a discipline, but has also influenced some of our important public policy debates, especially over the true costs of tariffs. He was one of the loose grouping of public servants, academic economists, corporate economists, financial journalists, backbench MPs and others who took on Australia’s long-established commitment to industry protection in the 1960s, and by doing so began the long process of dismantling the increasingly antiquated post-Federation economic institutions.

In 1982 Max proposed the three-sector model that has been revived a number of times, including in the last article that is being distributed today, that most usefully explains what is usually termed ‘Dutch Disease’ or the ‘Gregory effect’. I think it would have been better if it had been called the Gregory Effect , if I could say that. Because one of the problems with the whole Dutch Disease term is that a phenomenon that for most people is actually a profoundly good thing, is presented as a morbid condition – a counterpoint to the virility that you were talking about Gary. I noticed your hair is perfectly combed, by the way. This is of course the phenomenon where higher income and a stronger exchange rate caused by rapidly growing exports from one traded sector (classically, the resource sector) have a negative impact on other traded sectors.[1] And of course, the argument now is – and Max might touch on this – that the Dutch never suffered from the Dutch disease in the first place. That’s the Treasury’s received view – Martin Parkinson is nodding there.

Bob Gregory of course is here today as well and he’s another of our distinguished economists in the room. He produced the first research about this in 1976, which is why it sometimes known as the ‘Gregory Effect’. He is perhaps known best for his work on the labour market and a former member of the Reserve Bank board. [2]

Now they have published recent papers dealing on this and I will come back to these papers in a little while, particularly Max’s. But I just want to say something about the Gregory paper, which he wrote with Peter Sheehan. It looks at the recent divergence between GDP per capita and income-based measures of living standards as an increasing proportion of our growth in material well being having come from gains in the terms of trade (which are not captured in the former calculation or the former metric). He calculates that gap at $7500 per capita in 2011 dollars, which is a large chunk of what has been accrued over the past decade. It is worth pondering, perhaps we can discuss, how enduring that gain will be. [3]

Given there are so many great economists here I think I should going to focus my talk principally on the political economy of the matter. There is of course a great politician here, Dr Andrew Leigh, one of the Members from the People’s Republic of Canberra. And it’s good to see him, but I’m sorry you have to leave him before the discussion. It will be a pity.

Let me just outline a few propositions that should serve as constraints in the discussion. And I will say frankly in advance, if you accept them all, there isn’t much space left for a genuine attempt to ‘do’ something about the exchange rate.

The first point is that the wave of emerging market demand for commodities is much bigger than we are.

Everyone agrees that it is the sheer size of this resources boom that distinguishes it from previous commodity windfalls such as the late 19th century minerals boom, the Korean War wool price spike, or the buoyant energy and agricultural prices of the early 1970s.

And we have to bear in mind that the commodity boom that we’re talking about here in Australia is in large measure made up of the demand for the components of making steel. That is to say, iron ore and metallurgical coal. I will come back to thermal coal later. That demand is being driven by the rate of urbanization in Asia and in particular, of course, China. Now the steel intensity of economies peak when urbanization peaks and then over time starts to decline. So this is not going to go on forever. Steel intensity is not coextensive with economic prosperity. America uses much less steel now than it did 50 or 60 years ago. And the same will be true of China. A lot of people don’t reflect on this, but it is very important to bear in mind, particularly when people are trying to persuade you that this is a boom that will never end. I know there are a few people in this room who suspect that, or come close to arguing, that this is the case. So I would just make that point about urbanization, that this is a long term trend. It won’t go on forever, but it is a long term trend. This is not a spike.

The only episode that is comparable in terms of its economic impact was Victoria’s gold rush of the 1850s, which trebled the European population of Australia, made Melbourne into one of the great cities of the British Empire, and helped deliver the highest per capital incomes in the world for the next four decades.

Just in summarizing some of the metrics, and I know everyone here’s very familiar with them. The RBA index of commodity prices tripled between 2003 and 2009. In terms of investment committed or flagged for new resources sector projects, the January investment pipeline reported by Deloitte Access was $912 billion, with work going on at projects involving $415 billion. And in terms of duration, the episode has already outlasted all earlier booms save for the 1850s gold rushes. [4]

The bottom line here is, large though our resource industries and endowments are, in the end Australia is a tiny part of the market compared to an increase in demand in China or India. Even without investment in expanding our resources capacity, our exchange rate would still be significantly elevated compared to the period before 2003 given demand has been so strong. To complain about the current level of the dollar is to implicitly oppose not just current expansion of the resources sector, but its ex ante level of production.

In a sense by developing an iron ore or coal industry in the first place while having a floating currency and free capital flows, Australians signed on for the current ride.

The second proposition I want to make is about the dollar. This is the first – and Ric Battellino made this point in a very good speech last year – this is the first big boom, the first boom we’ve had, during which the exchange rate has been floating, and in which, and I’m quoting from his speech, “a significant rise in the nominal exchange rate has been an important part of the economic adjustment. This has added an important degree of flexibility to the economy by allowing the real exchange rate to rise through a means other than inflation.” [5] This is not our forst big boom, but it is our first big boom with a floating exchange rate.

Now my next proposition is that in my view, Australians are not going to reverse the past two decade of depoliticizing the exchange rate and interest rates. We’re not going to go back to governments, Paul Howes notwithstanding, setting the exchange rates or interest rates.

The contrast could not be more stark between the 2000s and earlier booms, as Treasury’s David Gruen described in his recent paper on the boom, when the exchange rate was still manipulated by politicians willing to do anything to avoid enraging farmers and manufacturers (which they would if the exchange rate had revalued). The result back then of income shocks was invariably inflation and industrial disputation as the higher wages in the fast growing sector, in the resources sector, flowed on to what max would call the lagging sectors and of course, created or contributed to very damaging inflation. One of these choices was arguably among the most costly policy miscalculations in our history - the Country Party’s repeated veto of a stronger dollar in 1971-72 which stoked the runaway inflation that ultimately averaged 9 per cent annually for the next two decades. [6] It took a long time to get over that.

Persistently high inflation combined with political meddling on official interest rates and the value of the currency in turn contributed to the macro-economic instability, recessions and low growth of the 1970s and 1980s.

Compare this with the record since our institutional arrangements were changed - first with the float of the dollar in 1983, and then later with the formalization of Reserve Bank autonomy and independence, and specification of an inflation target.

Since the float Australia has experienced only one recession (if we use the rule of thumb of two consecutive quarters of contraction) and that, in 1990-91, was the result of a conscious policy decision by the soon-to-be-independent RBA to finally break the back of inflationary expectations. The 1990-91 recession was a disaster in terms of human costs, but it did achieve its objective although at very high cost.

Against this backdrop, Paul Howes recently suggested the Reserve Bank’s mandate be altered to focus it on two objectives (price stability would be joined by the real exchange rate).

Given the struggles across much of manufacturing, where most of his members work, and Paul’s very enviable youth, it’s not hard to see why he might arrive at this suggestion. After all, it is quite a while, thankfully, since we have seen serious inflation at work in Australia or engaged in public discussion of its insidious effects.

The first thing wrong with Paul’s idea is that the RBA would be left with one instrument to aim at two targets - which implies one of them would have to be partly or entirely sacrificed at some point.

But an even more important criticism is that Howes implicitly downgrades the value of keeping inflation low, perhaps not realizing that if it edges higher, the costs tend to fall on the most vulnerable.

It is telling – very telling in my judgement and a marker of monetary policy success - that to find a quote best to explain this danger we had to go back to 1990, when Ross Gittins expressed the issue very well in an article. And I quote Ross Gittins:

“Inflation would be less of a problem if everyone had an equal ability to protect himself from its ravages. The ability to protect yourself from inflation, however, varies greatly through the community. Generally speaking, it's the better-off who have greatest freedom to protect the real value of their income and their wealth. The more you have, the more you can afford to get the advice and do the tricks that keep you ahead ... inflation hurts our society: it makes it less fair, with the less powerful and the less astute being the ones who lose out.” [7]

And surely the Australian Workers’ Union and its supporters would not want to do that.

Now Max Corden’s recent paper on policy options for a three-speed economy logically and convincingly makes a general argument that in an open economy amid a resources boom, any sector-specific policy we can devise is nothing more than a redistributive measure, either from consumers to producers, or from one group of producers to another. There will be negligible impact on the exchange rate.

He makes the point so compellingly that I think we can dismiss even considering such policies (unfortunately that is not so easy in the real world, where they remain popular). [8]

I might simply note for emphasis that invariably the loudest claims for assistance are from industries and firms whose comparative advantage is least apparent and whose history of Government assistance has been the longest, regardless of the exchange rate.

Add all of this up and the very limited scope to ‘do something’ about the high dollar becomes plain.

Max’s paper does propose one other approach - which is a strongly contractionary fiscal policy (Government spends less) offset by accommodative monetary policy (Reserve Bank cuts rates) with the aim being to leave demand at the same level but lower the effective exchange rate.

Of course such a strategy is very challenging to implement at the present time, where the aftermath of the GFC is layered on top of the resources boom, making it particularly difficult to know what ‘neutral’ settings for monetary and fiscal policy might be in Australia, much less what the current trade-off between them is.

Max notes that this could be a useful role for a sovereign wealth fund, a reform I have advocated. My understanding of his position is that he is agnostic as to whether a sovereign wealth fund invested in foreign currency denominated assets (and by that I mean uncorrelated foreign currency assets - so it would make no sense for us to invest a sovereign wealth fund in the RMB) would actually result in effective exchange rate sterilisation. And I think he’s right to be agnostic about that. I note that the Governor of Norges Bank said in 2010 that it is was still unclear, I think he said the jury is still out, whether Norway's SWF which at $550 billion or thereabouts has been effective in keeping the krone value even lower than it otherwise would be. And bear in mind their sovereign wealth fund, at %550 billion, is around 125% of Norway’s GDP. So a comparable Australian sovereign wealth fund would be a gigantic fund and obviously not something that could be achieved other than after a very long time.

So the exchange rate sterilization argument, in the context of investing in uncorrelated foreign assets I don’t think is a very powerful one. It might have some effect but it’s probably not going to be very material. The better arguments for a sovereign wealth fund relate to financial prudence and remembering that all booms come to an end and ensuring that when that does happen we will have something to show for it.

As to the exchange rate, I agree with Max that in an Australian context an Australian SWF – we already have one of course, the Future Fund. I’m talking about a new one or a second account if you like. This fund would assist in the fiscal consolidation exercise we both endorse and to pick up on something Martin Parkinson said the other day would result in savings being higher than they otherwise would be.

This behavioural aspect of SWFs is rarely discussed. The simple fact is, and we have seen it again and again in this city, that when Governments have money sloshing around they want either to spend it on benefits, invest in infrastructure or give it back in tax cuts. Sticking it in the bank is generally not very attractive, particularly when there is debt to be paid off and we saw this in the last years of the Howard Government when the Keating debt, so-called, had been paid off.

There is nothing wrong with any of those objectives if the spending or the investing or tax cutting for that matter is sustainable, well targeted and represents value for money.

Regrettably that isn’t always the case. Some of you have obviously fainted, shocked, at that proposition. And my argument is that it would be a salutory encouragement to greater thrift if an additional option was built into our thinking about public finances which was to save for our children and grandchildren's futures. And I say this as someone who’s been part of a Government and made collective decisions about spending. I am giving a behavioural economics perspective. You would struggle to quantify this or justify it in a quantitative way.

From a political point of view, my strong belief is that a commitment to a new SWF would be very much in the spirit of the times and would become a matter of real national pride. But it has to be said there isn't a lot of support for such a reform outside of the Business Council of Australia and many of its leading members, leading economists both academic and corporate, David Murray, Arthur Sinodinos, Peter Costello, the IMF and implicitly the Reserve Bank itself. And of course the Greens. But apart from that motley crew, there doesn’t appear to be much support for it.

There are many issues to discuss in relation to a new SWF, which of course may simply be another account managed by the Future Fund. These include the governance, the investment mandate of the fund and its nature. Should it be long term saving fund like the Norwegian fund, something we can live off when the oil runs out, probably not applicable to our resource endowment. Or should it be a stabilization fund like Chile's, which can be drawn down on when the commodity cycle turns down and government revenues decline?

My argument for a SWF as you can see is not driven solely or even largely by a concern about the exchange rate, and we have to always ask ourselves that while we may lament the high exchange rate as we empathise with producers, we should remember that the most important concern of politicians will inevitably be the welfare of consumers.

Of course the consumer benefits of a higher exchange rate are cold comfort if you dont have a job, but if you can combine a rising exchange rate, the sectoral adjustment that causes and yet maintain high levels of employment it is hard to see that the high exchange rate is an unalloyed bad thing as many would have us believe.

Compare the situation in China where you have a number, and Yiping Huang writes a lot about this, a Chinese economist. Or Michael Pettis, at Peking University has written a lot about this so probably a lot of you are familiar with it. But if you think about the Chinese economy, because consumers don’t have the same leverage there that they do in a democracy like ours, there are massive subsidies to producers and to State owned corporations at the expense of consumers. Negative real deposit rates, the transfer of between five and seven per cent of GDP from households to the banks to State owned corporations. That funding not being available to private corporations with a few exceptions that are national champions, like Huawei and others. And at the same time of course the exchange rate benefits exporters at the expense of consumers. So do we really want to do that? Is that the approach we really want to achieve? We have got to think about that, think about the consequences, when we complain about the exchange rate.

Now just consider, when we are told the exchange rate is unreasonably high, it is worth thinking back to the turn of the century when Australians were still being penalized because our economy was not exposed enough to the ‘new economy’ boom, so called.

Because of this and low commodity prices in the year 2000, GDP per capita at market exchange rates was $US35,300 in the US and a mere $US20,800 here.

What a difference the past dozen years and a change in investor perceptions has made.

By 2008 per capita incomes in Australia and the US expressed in market terms were the same, for the first time since 1895 and by 2012, the IMF forecasts GDP per capita of $US49,100 in the US and a startling $US69,000 in Australia. So the reality is that the high exchange rate is a feature in a turn around in economic conditions that has made all Australians wealthier but of course has had serious issues of adjustment. But it is something we should be proud of, that we have been able to achieve that process of adjustment while still maintaining relatively high, historically high levels of employment. And that is something we should be very proud about.

Now I am just going to make one final point because we can talk a lot more in the discussion. But my simple point is this: There is always an attraction to what I used to call many years ago, the ‘Backslash Copy’ school of economic forecasting. Those of you who can remember using Lotus 123, so it’s only the older people in the room who know what I’m talking about. The disruption caused by technology, discover and innovation is not limited to the world of social media.

Just think for a moment of the revolution in natural gas. That is a vast topic for another occasion. It was only a few years ago that the United States was lamenting that it was running out of energy and that it was going to become a massive gas importer. Gas is now cheaper relative to oil, by relative values on a BTU basis, than it has ever been. And of course America will become a major gas exporter. And that is going to have a very material impact on the price of gas in Asia. The price differential in the United States and gas in Asia – because the markets are not presently connected – is gigantic. Now trade will resolve that.

What has made that possible? Horizontal drilling and fracking. Technology has made that possible. The gas has always been there, it has been there for millions of years, no doubt. China is a gigantic coal province, it has more coal reserves than any country in the world. It has, inevitably, equally vast resources of gas – unconventional gas, shale gas, coal seam gas.

Now there are people in Beijing that I have spoken with who believe China will become self sufficient in gas eight years or more from now. And more than that, it could become an exporter of gas. Now we are dealing with high levels of uncertainty here, so I wouldn’t make any financial investments on what I am saying to you, or anything I have said to you. But imagine if China becomes self sufficient in gas. I think that is very realistic. But imagine if China becomes an exporter in gas. America will become an exporter in gas. What does that mean for the value of our gas reserves and the value of our gas exports? What will happen if technologies to make steel without metallurgical coal become available? And there is a lot of work being done, but I think they’re a long way off, but who knows.

We should not assume that rapid disruption is limited to the world of the internet. The world of resources is subject to it just as much. And sometimes those shifts, while perhaps they take a little longer to take effect can be even more momentous. So prudence and thrift are good qualities to bear in mind in these uncertain, but nonetheless very prosperous, times. Thankyou very much.

[1] W. M. Corden & J. P. Neary (1982) ‘Booming Sector & De-Industrialisation in a Small Open Economy,’ Economic Journal 92, pp. 825-848. This and subsequent research modeled an economy experiencing rapid growth in income from one type of export in terms of three stylized sectors: a booming sector (such as resources or energy), a lagging traded sector (such as manufacturing or agriculture), and a non-tradable sector (such as services or government).
[2] R. Gregory (1976) ‘Some Implications of the Growth of the Mineral Sector’, Aust. Journal Agric. Econ. 20, pp. 71-91.

A third important contribution to the early economic literature about resources booms was also published by an Australian economist, Richard Snape (1936-2002) who later became deputy chairman of the Productivity Commission. See R. H. Snape (1977) ‘Effects of Mineral Development on the Economy", Aust. Journal Agric. Econ. 21, pp. 147-156.

[3] R. Gregory and P. Sheehan (2011), "The Resources Boom and Macroeconomic Policy in Australia", available online at:, p.11

[4] Wayne Swan & Lindsay Tanner (2010) Budget Paper No. 1, 2010-11, pp.4-4 to 4-5.

[5] Ric Battelino, Deputy Governor, RBA (2010) ‘Mining Booms & the Australian Economy,’ speech to Sydney Institute, 23 Feb 2010, published in RBA Bulletin, Mar Qtr 2010, p.67

[6] Country Party then Whitlam: David Gruen, Australian Treasury (2011) ‘The Macroeconomic and Structural Implications of a Once-in-a-Lifetime Boom in the Terms of Trade,’ speech to ABE, 24 November 2011, pp.6-7.

[7] Ross Gittins, Sydney Morning Herald (1990) ‘Why High Inflation Makes Us Losers,’ 2 May 1990.

[8] W. M. Corden (2012) ‘The Dutch Disease in Australia - Policy Options for a Three Speed Economy, Melbourne Institute of Applied Economic & Social Research, Working Paper No. 5/12, Feb 2012

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