James Morley

I am a member of the “shadow” Reserve Bank of Australia (RBA) board, which is made up of a collection of industry and academic economists. Just before every meeting of the real-world RBA board, we announce our recommendations for monetary policy.

Prior to the February meeting, we argued that RBA board members should hold the policy rate steady at 2.5%. But they cut the rate for the first time in 18 months to 2.25%. This was a surprise to many, including financial markets which responded with big gyrations in the dollar and equity prices.

So did we, like many others, simply get it wrong?

Not really, because a key distinction between the shadow board and many market commentators is that we are supposed to recommend what the RBA should do, not predict what it will do.

Of course we hope that the reasons behind our recommendation are so compelling that the RBA would come to the same conclusion, even if it does not directly follow our advice. So this distinction between what it should do and what it will do gets blurred somewhat in practice.

What to make of the RBA cut then? Did it make a mistake?

The short answer is “not exactly”. (I know, you’re thinking that’s a typical two-handed economist answer to a simple question. But I will explain.)

In my recommendation not to cut, I focused on the huge recent drop in oil prices. I argued that this contributed to a temporary decline in inflation below the RBA’s target range of 2% to 3%, with the latest CPI annual rate at 1.7%.

I acknowledged that low inflation provided some scope for the RBA to cut rates. But I suggested that the fall in oil prices, along with the fall in the dollar and robust growth in the US, would help broaden growth beyond interest-rate-sensitive sectors such as the housing market. So a cut could be delayed until the RBA had better prepared financial markets for one.

In the policy statement and the subsequently released minutes from its February meeting, the RBA actually covered a lot of similar ground, albeit in much more detail.

The big difference was the RBA emphasised that the unemployment rate would, according to its forecasts, peak at a higher level than previously thought. This change in the forecast was driven in part by revisions of GDP data which suggested weaker growth over the past year.

Given this new information and the RBA’s modelling of how it changes the forecast for the unemployment rate, an immediate cut in the policy rate was deemed to be the best course of action. Its concerns were subsequently confirmed by the latest unemployment rate data that showed a jump up to 6.4% in January, the highest rate in more than 12 years.

So the RBA looks prescient. At the same time, trying to prop up demand in a way that stimulates the housing market has its risks. The US experience in the early 2000s makes this abundantly clear. Ultimately, we won’t know whether the RBA made the right call for years, if ever.

The last shadow board recommendation wasn’t actually as simple as saying the RBA should hold rates steady. In general, we acknowledge uncertainty about the appropriate level for the policy rate by assigning probabilities to different possibilities. Think of this as like placing bets on what is the right thing to do.

Averaging across all of our members, we assigned a 68% probability that the appropriate policy was to hold steady, with a 13% probability for a cut and a 19% probability for a rise.

Importantly, we assign individual probabilities without conferring first. This is designed to avoid “group think” and there is a fair amount of variation in recommendations across members. (In February, I assigned 65% to holding steady, 20% to a cut, and 15% to a rise, which wasn’t too far off the average probabilities. The reasons for these probabilities can be discerned from my current and past written comments.)

Unfortunately for those who might enjoy a little controversy, we’re not in this to criticise the RBA.

This is in contrast to the original “shadow” Fed in the US, which was founded in the 1970s. It was quite critical of the Federal Reserve’s policy at the time, not just in terms of policy actions, but its whole policy framework.

Monetary policy has changed a lot since the 1970s, with the adaption throughout much of the world of the remarkably successful Kiwi export of inflation targeting. This policy framework emphasises transparency and a nominal anchor (that is, stable CPI inflation) that stands in stark contrast to the secretive and scattershot policies that were carried out in the 1970s.

The RBA has an inflation target and it is guided in its policy actions by forecasts of inflation and the unemployment rate. It explains in a transparent way why the policy rate is set at a given level, including how it will bring inflation within its 2% to 3% target range.

This framework has allowed the RBA to achieve very close to 2.5% inflation on average since the introduction of inflation targeting in 1994. So it is hard to be critical of the policy framework.

So what is the shadow board’s role then? I believe one answer is to provide some independent thought on monetary policy, including why it can sometimes make sense to raise rates, rather than cut them.

I’ve noticed a fairly unremitting enthusiasm in the financial press for rate cuts. And these do stimulate the economy, so why not? The answer, of course, is that these rate cuts can also lead to inflation and various imbalances that create long-run pain after the short-run gain.

At the same time, we need to avoid what Paul Krugman refers to as VSP (“very serious people”) syndrome, which leads to a constant and highly irresponsible call for short-run pain to somehow prove our economic virtue.

Despite such economic bloodletting being equally as bad as the long-discredited medical version, VSPs keep pushing their shockingly bad advice and sometimes even get to try it out with fiscal policy.

Monetary policy will always involve dilemmas with no easy solutions. A record low policy rate of 2.25% helps the Australian economy adjust to the end of the mining boom. But it almost certainly overstimulates the housing market, which will cause problems down the road.

The shadow board won’t provide a definitive answer as to what the RBA should do. We are clear about our own doubts. But we try to think through the possibilities in an objective way and hope to contribute to the public discourse on monetary policy.

Just don’t ask us to predict what the RBA will do at the next meeting.

James Morley is a professor of economics and an associate dean at UNSW Business School. A version of this post appeared on The Conversation.

Tim Harcourt

What an amazing time it’s been for Australia and India lately. With talks of a free trade agreement (on the coat tails of agreements with Korea, Japan and China), and “Modi mania” in Australia after the G20 as Indian Prime Minister Narendra Modi took Australia and the world by storm with his mandate to build a new India.

And then we saw India’s cricket fans, the “swami army”, swarming into the newly renovated Adelaide Oval for the historic India-Pakistan World Cup qualifier.

In fact, the India-Pakistan cricket match was beamed around the world and was estimated to have been the most-watched in the history of the game, in terms of TV viewers.

Also, Indian and Pakistani fans travelled to Adelaide, not only from South Asia but from Singapore, too, and some even came from as far away Toronto to be there for the first ball.

More than 80% of match attendees hailed from outside South Australia (SA) with large groups of Australia’s Indian and Pakistani communities making the journey across from Sydney and Melbourne. Indian and Pakistan flags were seen flapping from cars at the Victoria/SA border and Indian commentators thought Adelaide airport temporarily looked like any Indian airport in the middle of an Indian Premier League (IPL) series.

SA Premier Jay Weatherill hosted a key community function for Indian businesses on the Thursday before the match and a historic India-Pakistan business function was held at game. The game itself (which India won comfortably), had everything except the SA Tourism Minister catching a six, which he has done previously at Adelaide Oval.

The huge crowd in Adelaide is indicative of how the Cricket World Cup has been attracting cricket-lovers from near and far and of the related business opportunities, particularly in tourism. According to Cricket Australia’s Jonathan Rose: “Around 825,000 tickets have been sold and we expect to hit one million by mid tournament.”

Rose points out that even cricket newcomers such as Afghanistan played to a sold-out crowd in Canberra against Bangladesh (thanks to many of the Bangladeshi community in Sydney and Melbourne, who travelled to the game) and “that’s even before we count the Australia-England or South Africa-India blockbusters”.

As an economic moneyspinner the Cricket World Cup is growing, partially because the cost of broadcast rights has doubled for the International Cricket Council (ICC) due to the popularity of the game in India – especially the short forms of the game.

It is estimated that 70% of the world’s cricket revenue is generated from India and that’s why having the Indian team based in Adelaide was important to SA and why India is so influential in the ICC.

But how does the Cricket World Cup compare to other international sporting tournaments? It is estimated that it generates the equivalent of about 50% of the revenue the FIFA World Cup achieves, making association football/soccer truly the world game.

But cricket makes about 10-times the revenue generated from rugby union’s premier international tournament, the Rugby World Cup, which is being staged in the UK later this year.

In fact, the cricket-soccer comparison is important in the Australian context as both are local summer sports (given that Australia has three leading winter football sporting codes in Aussie rules, rugby league and rugby union) and Australia has just hosted a very successful soccer Asian Cup, which our Socceroos won in a thrilling final against South Korea.

According to Alison Hill of the AFC Asian Cup Local Organising Committee, the Australian community really took to the tournament as a whole, even in games where the Socceroos weren’t playing.

Hill estimates that “there were 650,446 match attendees, at an average of more than 20,326 [a game], with 380,000 attendees to matches that didn’t involve the Socceroos”. The TV audience was again massive with at least 315 million watching the tournament in China, Japan, South Korea, Australia and ASEAN nations alone.

So with the Asian Cup a success and the Cricket World Cup attracting fans globally to Australia and New Zealand, it’s a big year in the economics of international sport. And the associated benefits in tourism and marketing, not to mention “sports diplomacy” as exhibited by SA business hosting the India-Pakistan match at Adelaide Oval, shows it’s all much more than just a game on the world stage.

Tim Harcourt is the J.W. Nevile Fellow in Economics at UNSW Australia Business School and author of Trading Places and The Airport Economist.

Richard Holden

The great American baseball player, Yogi Berra, was reportedly once asked by his exasperated high school teacher: “Don’t you know anything?” He replied: “I don’t even suspect anything.” Clever.

I have always feared that for Prime Minister Tony Abbott, his grasp of economics can be similarly described, but without the witty repartee. It’s not beyond him but he doesn’t seem to care. It’s pretty obvious that he doesn’t know much about economics.

But that’s OK, I’m not sure Bob Hawke did either, and he presided over some of the greatest economic changes in Australia’s history. It’s the fact that Abbott doesn’t “suspect” anything, either; that may be his downfall.

Economics, for Abbott, is boring. According to people who know him well, he has no interest in the subject whatsoever. The funny thing is that people who knew the late Gough Whitlam well say strikingly similar things. He didn’t care about economics either.

Abbott moralises about matters economic. Debt is bad because of interest payments; companies should not get “corporate welfare”; we must live within our means.

I agree with several of the policy implications, but not because of morals, because of economics. Government shouldn’t subsidise bad car manufacturers because that’s a lousy way to try to create jobs. Government shouldn’t spend more than it earns except to stimulate the economy in very rare crisis moments. Debt is fine if it’s used for productive investment, but terrible if used for recurrent expenditure.

Abbott and Whitlam both became prime ministers in difficult and new economic times. For Whitlam it was “stagflation”: oil shocks, inflation, and the breakdown of the view that a Treasury department could control an economy like it was a remote-control car.

For Abbott it is “secular stagnation”. Former US Treasury secretary Larry Summers described it, aptly, this way: “In sum, I would suggest to you that the record of industrial countries over the last 15 years is profoundly discouraging as to the prospect of maintaining substantial growth with financial stability … changes in the structure of the economy have led to a significant shift in the natural balance between savings and investment, causing a decline in the equilibrium or normal real rate of interest that is associated with full employment.”

Whitlam failed, in no small part, because of his disregard for economics and his disrespect for the power of economic forces. Abbott is currently falling into the same trap. And if he doesn’t mend his ways, fast, he’ll end up in the uncomfortable place that Whitlam did – a casualty of economic forces.

Abbott is a likeable Prime Minister. He seems to have a greater love of this country than any political leader in my lifetime. He’s a good Burkean: cautious, prudent and appropriately skeptical of what government can achieve, but not contemptuous of government and the role it can play. He’s someone I would trust to take the “3am phone-call”.

But a good deal of what we need now is someone who can help us navigate the pressures of an ageing population; a tapering mining boom; and a relentless increase in global economic connectedness.

All of that means that, as things stand, government expenditures will grow at a much greater rate than government revenues. And that structural deficit problem, unchecked, will destroy the Australian social bargain.

This means that old-style tax bases are not up to the task. The stuff government does costs a lot more every year: medical technology gets better but more expensive, wage growth for skilled people is above inflation, the pool of people we provide benefits to is growing.

If Abbott does fail to hold on to the leadership I have little doubt that history will record it was economics that did him in. And if he succeeds, I suspect it will be because he finally persuaded Australians that if government expenses grow faster than government income for too long then disaster occurs. Economics 101.

Abbott explains that fact roughly like this: “We can’t pay ourselves more than we earn and piling up debt today is intergenerational theft.”

I’d put it like this. If tax receipts continue to grow at 3% a year and government expenditures continue to grow at 7% a year, then in 5 years our debt will be x% of GDP, in 10 years our debt will be y% of GDP, and in 20 years it will be z% of GDP.

Or perhaps like this: “Today we’re Australia, and we will be tomorrow. But if we don’t change our spending and taxing habits then basic arithmetic says that in 5 years we’ll be the US, in 10 years Italy, and in 15 years Greece. In 20 years we’ll be Paul Keating’s banana republic.”

Abbott may have ascended the prime ministership against the backdrop of a morality play. But the challenges we face are largely economic. Abbott needs to get that. And he should use a lot more of his considerable intellect worrying about economics, not morality.

Richard Holden is a professor of economics at UNSW Business School. A version of this post appeared in The Australian Financial Review.

Richard Holden

There continues to be a lot of discussion about the future of tertiary education in Australia. Should fees be deregulated, places capped, interest on student loans charged at the bond rate? And on, and on.

In all of this debate, however, there has been across-the-board praise for the HECS system, designed by economist Bruce Chapman and implemented by the Hawke-Keating government. And rightly so: it allows students to pay their share of the cost of their education over time, and do so contingent on income.

This does two things. First, it provides credit to students, thereby eliminating the need to have up-front cash to pay tuition fees. Second, it provides insurance against labour market risk. Loan payments are only due when a solid income is being earned.

All good, right? I sure thought so. Yet education policy scholar Peter Noonan recently said: “Anyone who thinks that a system that blunts price signals can simply underpin price deregulation doesn’t understand economics.”

Then University of Melbourne vice-chancellor Glyn Davis told The Australian: “HECS does blunt price signals but we don’t know whether it blunts them so much that it won’t work.”

Really? The argument seems to be that in a deregulated fee environment, an income-contingent loan (HECS) means prices aren’t as informative as in a market without HECS.

Well, I do understand economics and I beg to differ. In this market, HECS makes prices more informative, not less.

To see why let’s first be clear about just what a “price signal” is. The reason why people like me are fans of markets is because the market’s price mechanism has a remarkable ability to aggregate and communicate information. It can do what no central planner could ever hope to do.

My favourite story about how remarkable the price mechanism is in this regard comes from when I was living in Boston. I used to go to my local supermarket every day, and they had in-store-squeezed orange juice. One winter day, which seemed indistinguishable from the last, I noticed the price had more than doubled from $3.25 to $7.00. I also noticed an employee with a pricing gun changing the price of other juices in the refrigerator.

What had happened? It turned out that 18 hours earlier there had been a frost in Florida that had damaged orange trees, disrupting future supply. This had become known to traders, frozen concentrate orange juice prices had shot up, and local suppliers of oranges had raised their prices immediately in Boston. The supermarket manager, realising that in-store-squeezed juice and bottled juice were close substitutes raised the price of those, too. All in 18 hours — and all through markets.

So in a deregulated market for tertiary education in Australia, what would be the price and what information would it convey? The price, of course, would be the cost of tuition. A high price would suggest a valuable degree – perhaps because of field of study (such as, law or medicine), because of university reputation, or because of the quality of the education and educators. Right now prices are all essentially the same – so no price signal.

Different potential students have different information and perspectives on the value of those disciplines, universities, and faculties. The magic of the market is that the price of various degrees — in a deregulated market — aggregates and assembles all that dispersed information. This point was made forcefully by Austrian economist Friedrich Hayek in 1945 and was later formalised by the great American economist Sandy Grossman.

Now, there’s other information besides prices: rankings, word of mouth, ATAR cutoffs, and more. So prices wouldn’t be the only source of information in a deregulated tertiary education market, but still a very important one.

The key thing to understand in all of this is that most students are credit constrained. They don’t have accumulated cash to pay tuition up front. So they have to borrow. HECS allows them to do that on very generous terms. But suppose there was no HECS. What would happen?

Without the private loan market stepping in this would mean a whole host of students could not afford to pay for university. So they would not participate in the market. This would be terrible for them, but also terrible for the market. Their valuable information about the future would not be incorporated into the price for tertiary degrees and that would make even those who could afford to participate worse off.

The bottom line is that for markets to work well they need to be liquid — they need to have a lot of participants. The more liquid they are the better they are at aggregating and communicating information. When a huge chunk of people are credit constrained and can’t participate in the market that’s bad for them and bad for the market. Letting them in, as HECS does, sharpens the price signal.

Would it be sharper still without income contingent repayments? I think not. That would make students bear more labour market risk and drive more students out of the market for tertiary education. Both efficient risk-sharing and efficient credit-provision makes price signals better. And that’s precisely what HECS does.

The trap that Noonan and Davis have fallen in to is to think that because HECS makes students less responsive in their decisions to changes in prices it makes prices less informative. Not so.

It is an understandable mistake, for well-functioning markets do two things. They equate supply and demand, and they convey information. Both are pretty important. But it’s the latter that is what a price signal is really all about—particularly in a market such as that for tertiary education with dispersed information and a good deal of uncertainty about the future.

Hayek would have liked HECS. It helps, not hinders the market weave its magic. It makes the price mechanism work even better. It’s time to stop apologising for it.

Richard Holden is a professor of economics at UNSW Business School. A version of this post appeared on The Conversation.