James Morley

The major Australian banks have recently cut fixed mortgage rates below 5%. They have done so without any prompting from the Reserve Bank of Australia (RBA), which may actually start raising the policy rate within the next six months, especially if inflation continues to run around the top end of its 2% to 3% target range.

Why, then, did the Australian banks cut their mortgage rates?

One possible reason lies in an obscure old macroeconomic theory of “secular stagnation”  which has been gaining credence recently throughout the financial industry worldwide.

In a speech at the International Monetary Fund last November, Larry Summers, Harvard economist and former US Treasury Secretary, resurrected this old theory, originally developed by another Harvard economist, Alvin Hansen, in the late 1930s.

When a consumption-led recovery in the midst of the Great Depression started to falter, Hansen was inspired by the then nascent Keynesian idea that the economy as a whole could persistently suffer from inadequate demand in the absence of a massive policy intervention.

US population growth had slowed dramatically during the Great Depression and Hansen believed this was a “secular” (that is, long-term, non-policy) source of decline in private investment in new capital infrastructure.

According to his very Keynesian theory, this weak investment brought consumption down with it and, like John Maynard Keynes, Hansen did not believe in the ability of wage and price adjustment to restore the economy to full employment in the face of inadequate demand. Instead, he believed that fiscal policy would have to take up the slack, which it did with the onset of World War II.

The baby boom after the war meant that the theory of secular stagnation was largely forgotten. But Summers sees similar forces at work in recent times and he considers secular stagnation as a leading explanation for why the US housing bubble in the 2000s didn’t result in an overheated economy at the time.

One might question the idea that the US economy didn’t overheat prior to the Global Financial Crisis. But real GDP growth and inflation were actually quite moderate by historical standards throughout the 2000s. Summers speculates that this was because economic growth would have been much slower in the absence of a bubble due to secular stagnation.

This story is somewhat related to former Federal Reserve chairman Ben Bernanke’s “global savings glut” hypothesis about why interest rates remained so low throughout the 2000s. In Bernanke’s view, there were too many savers, especially from Asia, chasing too few high-return and often risky investments. This “chase for yield” put downward pressure on interest rates and fuelled the US housing bubble.

So what is the prediction of secular stagnation for the future and why might it explain the Australian banks’ recent cuts in mortgage rates?

The basic prediction of the theory is that economies throughout the world will continue to stumble along with anaemic growth and no inflationary pressures for the foreseeable future. At best, there will be more moderate growth from time to time, but it will occur due to periodic financial bubbles triggered by a chase for yield and low interest rates.

Faced with slow economic growth and low inflation, central banks will contribute to these bubbles by lowering their policy rates or making large-scale asset purchases (aka quantitative easing) when rates hit the zero lower bound.

In cutting their mortgage rates, the Australian banks appear to have bought into the secular stagnation theory and are clearly betting on continued downward pressure on interest rates driven by a global chase for yield.
Can anything to be done about secular stagnation or, perhaps, is its relevance to the current economic situation overstated?

Similar to Hansen in the 1930s, Summers argues that public investment in infrastructure provides the best way to address inadequate demand. He notes that current low interest rates also mean that the cost of financing public infrastructure investment is unusually low.

Would this fiscal policy approach work? Japan is an obvious place to look at in terms of what might happen in the face of demographic-led stagnation. And the results are not particularly promising.

Japan has undertaken massive debt-financed infrastructure spending and this has not exactly produced a booming economy. Of course, unemployment has remained low and deflation, not inflation, has been the greater problem. So perhaps things would have been even worse in the absence of Japan’s massive fiscal interventions.

Meanwhile, it’s not really clear how relevant secular stagnation is for the rest of the world, including Australia. Indeed, in an odd way, the possibility of secular stagnation means that we should at least briefly celebrate when we see Australian inflation running at the top end of its target range.

This is not to say that the RBA should abandon or revise up its inflation target. But higher inflation is an indication that the secular stagnation hypothesis may be incorrect, while the RBA can always raise its policy rate to bring inflation down again in the future.

Of course, the Australian banks currently betting on low interest rates won’t be quite as happy if this scenario were to play out.

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

James Morley

What are the risks in the economic outlook for Australia?

Typically, prognosticators take a scenario-based (aka “story-telling”) approach to answering this sort of question. And usually these scenarios end up as a litany of woes about what the future holds (such as weak productivity growth, unfunded fiscal liabilities, and highly unfavourable demographic trends).

But for most economists, the more natural approach to answering this question is to consider formal econometric analysis of the macroeconomic data.

Without going into the gory details of how to do this, I want to provide a sense of what such analysis says about the short-run and long-run risks in the economic outlook for Australia.

I consider two key indicators of economic activity: output growth and inflation. The short-run risks are captured by statistical distributions for these indicators, while the long-run risks relate to possible changes in these distributions.

The graph below plots output growth for Australia and the US.

It’s clear from the graph that output growth for both countries has been much less volatile since the mid-1980s. Economists, who like to label everything as “Great” (e.g. the “Great Depression” and the “Great Recession”), refer to this stabilisation as the “Great Moderation”.

Even a casual glance at the graph makes it clear that the Great Moderation was not a myth, as has been asserted by some commentators, but is very real. Yes, the US economy had large negative growth rates in 2008. But since then, output growth has been stable, if lacklustre. Australian output growth also remained stable throughout this period.

The reasons behind the Great Moderation are highly contested. But at least a couple of leading explanations suggest it should persist in the future. The most compelling explanation is that the economy now faces “smaller shocks” due, in part, to a changing structure towards services and away from manufacturing (though the reduced volatility occurs within services and manufacturing, not just due to their shifting importance).

Also, monetary policy likely played some role by stabilising inflation, leading to fewer movements along the “Phillips curve” (the short-run link between inflation and output). Note, however, that US output growth remained stable after the global financial crisis, despite the US Federal Reserve facing a “zero lower bound” constraint on interest rates. So a paramount role for monetary policy in stabilising output growth is doubtful.

Consistent with the visual impression in the graph above, formal tests suggest the statistical distribution for Australian output growth has remained fixed since the mid-1980s. Based on this distribution, the short-run outlook has real GDP growing at a 3% annualised rate, with a standard deviation of 1.5 percentage points for year-on-year growth summarising the risk in this prediction. In words, output growth could well be 1.5% or 4.5%, but there is a low probability that it will be less than 0% or greater than 6%.

Notably, a major recession along the lines of what happened to the US in the global crisis is extremely unlikely based on this distribution, although other statistical modelling suggests the probability of some sort of recession for Australia is less remote, but still small, at close to 15% during the next two years.

The graph below plots inflation for Australia and the US.

This graph shows that Australian inflation has been lower and less volatile since the early 1990s, especially in comparison to the 1970s. This pattern of stabilisation roughly mirrors that of US inflation, also plotted in the graph, although the timing is a bit later in Australia.

The stabilisation of US inflation in the early 1980s coincides with major changes in the Federal Reserve’s monetary policy at the time, while a link to monetary policy for Australia is strongly supported by the anchoring of inflation expectations (such as the measure also reported in the inflation graph based on the difference between yields for 10-year nominal and real Australian government bonds) at the start of the inflation-targeting era in the early 1990s.

Consistent with the visual impression in the inflation graph and similar to output growth, formal tests suggest a fixed statistical distribution for Australian inflation in recent years, albeit since the early 1990s only when inflation targeting was put in place.

Based on this distribution, the short-run outlook has inflation at a 2.5% annualised rate (exactly the midpoint of the Reserve Bank of Australia’s target range), with a standard deviation of 1.3 percentage points for year-on-year inflation summarising the risk in this prediction. In words, the headline inflation rate could well be 1% or 4%, but it is unlikely that it will be much more extreme than that.

A major recession might push Australian interest rates to the zero lower bound, along the lines of what has happened in Japan, the US, and Europe. However, if the RBA were to follow similar unconventional policies to those conducted by the Federal Reserve in recent years, the US experience suggests that inflation volatility should remain contained.

The main long-run risks for the Australian economy are that the statistical distributions of output growth and inflation could change in some fundamental way, as they have in the past.

Given the reasons for the past changes discussed above, it seems unlikely that output growth and inflation will return to their pre-Great Moderation patterns. A downside of this is that long-run output growth now appears to be lower than it was in the 1960s and 1970s. Furthermore, there is always a risk that long-run output growth could fall further.

It is notable that the average growth rate for the Australian economy was as high as 5% in the 1960s when worldwide productivity growth was high, but has only been 2.8% over the last decade. At the same time, average growth has been reasonably steady since the mid-1980s. So an imminent end to economic growth, as might be suggested by the most dire scenario-based analysis, is quite unlikely.

The key point is that to really understand the risks in the economic outlook, it is important to step back from a story-telling approach, no matter how compelling, and take an  objective look at the data. Doing so provides some encouraging bounds on the likely risks for the Australian economy.

James Morley is a professor of economics and Associate Dean (Research) at the Australian School of Business. A version of this post appeared on The Conversation.

Geoffrey Garrett

This week’s Australian Budget was clearly highly political. The question is what its economic impact will be.

My overall assessment is that the Abbott government has burnt too much political capital for too little economic gain.

Tony Abbott is likely to be hoisted on his own petard. He won office by attacking Labor for creating a budget emergency and by focusing on former prime minister Julia Gillard’s broken promises.

But there is no budget emergency and Abbott’s record of broken promises seems broader and more systematic than Gillard’s slippage from a floating to a fixed carbon price.

The combination of broken promises that hurt the Howard battlers will haunt the government. This means very heavy political sledding for Abbott, particularly tough given how poorly his government did in its first six months and his and his party’s attendant slide in the opinion polls.

But irrespective of the fate of the government, the biggest casualty is that no one will have any appetite to take on the fundamental structural issues everyone on both sides of politics knows must be on the agenda.

Increase and broaden the GST. Empower or emasculate the states in health and education. Tighten pensions and tax superannuation. Not to mention the across-the-board deregulation needed to promote innovation, competition and, ultimately, productivity.

This is really what Treasurer Joe Hockey’s consistent narrative on ending the age of entitlement is all about. The Budget was supposed to be the first step, with relatively small (1%) GDP improvement over the four years of the forward estimates, a signal of more to come in the out years, and a provocation to start a mature political discussion of the really big issues.

Instead, the political debate will focus on relatively minor changes in policy inflamed by charges of broken promises.

Doing nothing, we were told, was not an option for Australia. Well, the Budget did something. The problem is that it did too much for electoral comfort but too little for structural economic change.

Take the decision to reverse the Gillard/Rudd commitments on increased funding to the states for healthcare and education.

Hockey has been in your face to the states in the past 24 hours, telling them health and education are their problem and they should raise their own revenues to fund them.

What Hockey seems to be doing is provoking the states, mostly with fellow travelling Centre-Right governments, to build the case for increasing the GST — collected in the states for spending in the states.

But the premiers know this is politically radioactive on multiple dimensions. The much safer path for them is to blame Abbott for insufficient funding from the Commonwealth.

The end result will be lots of political pain all around. Poor delivery of key services at the state level. No fundamental tax reform.

There seem to be only two ways the Budget won’t have this bad outcome.

The better alternative, for everybody, is that the Australian economy bounces back very strongly in the next 18 months. Unfortunately, this seems unlikely given that the US Federal Reserve’s commitment to tapering will push up interest rates around the world, with China’s Xi Jingping doing all he can to resist the temptation of another 2009-like stimulus as 7%, not 12%, becomes the new normal for Chinese growth.

The worse alternative, much worse, is a real economic crisis, like that driven by the last real root and branch reform of the Australian economy — the very tough budgets and radical regulation of Paul Keating’s “banana republic” reformism of the mid 1980s.

Australia is fortunately in a much stronger position today than it was then. The ironic downside to this is that the country just doesn’t see a major problem with how the economy is tracking.

The term “too good a crisis to waste” was gallows humour in many Western countries in the dark days of 2009. But some did use the crisis fundamentally to restructure their economies. There was no crisis in Australia, just an acceleration in the spending that began in the latter Howard years.

Fast forward to today. Hockey and Abbott did more in the Budget than Australia was comfortable with but less than we need. They may end up being political casualties, but in the long run the country will be the real loser.

Professor Geoffrey Garrett is the dean of the Australian School of Business at the University of NSW. This opinion piece has appeared on The Conversation.

Richard Holden

You can’t fault a treasurer for trying to put the best possible spin on Budget numbers — and that’s certainly what Joe Hockey has done.

The most important numbers, of course, are the deficit projections  – A$49.9 billion this year, falling to A$2.8 billion in 2017-18, the final year of the forward estimate period. Quite a hockey-stick.

Looking at the forecast numbers in a chart reveals a nice, smooth, downward, exponential pattern. And that is no accident.

But as always, the future amount of revenue and expenditure that the Budget deficit stems from are uncertain. Revenues largely come from tax receipts and they depend critically on how fast the economy grows. Expenditures are a little more certain, but again depend on factors such as the unemployment and inflation rates.

The Budget estimates assume GDP growth of 2.5% next year, increasing to 3% and then 3.5% over the forward estimates period. And that’s where the rabbit goes into the hat in Hockey’s deficit forecasts.

It would be hard to argue that growth will be much higher than 2.5% next year.

First of all, estimates for the near future are almost always better than those for the medium and long term. Second, there is a pretty strong consensus among economic forecasters that growth won’t be higher than 2.5%. What about the 3.5% GDP growth assumption for 2016-17 and 2017-18?

Well, it could happen. It would be nice if it happened. It would also place Australia among the fastest growing advanced economies in the world. In short, it’s no sure thing.

On the flipside, cost growth is assumed to be relatively contained. Inflation is assumed to be 2.5%, which is not a crazy assumption, but actual inflation could certainly be higher. Since a range of benefits expenditure is linked to the Consumer Price Index, this is an important driver of government expenditures.

The bottom line is that the nice, smooth, exponential decline in forecast deficits comes from just that — forecasts. And while those forecasts do involve a great many detailed categories, they are far less “bottom up” than, say, a household budget.

Assumptions are made on macroeconomic aggregates like GDP growth and inflation, not how much a family’s health insurance or mortgage payments will cost. And while that’s inevitable, it does mean that there is a lot of uncertainty about those future numbers. They could be better, but they could be significantly worse.

Then there’s the claim about debt levels: both what was inherited from the previous government and where it will go in the coming years. Where it will go depends on the actual deficits over the forecast period, so it depends on the factors just mentioned.

As to the line that the current government “inherited $667 billion in debt” — well that’s false. And it’s false for multiple reasons.

The number is a projection for government debt at the end of the decade, it includes a range of actions by the current government (such as paid parental leave, removing the carbon and mining taxes, direct action on climate change, and others), it is not relative to GDP, and most importantly it is a projection about gross debt, not net debt.

Net debt compared to GDP is what matters. Net debt is basically what we owe minus what others owe us. Gross debt is not relevant for our credit rating or ability to service debt.

Indeed, when the government talks to ratings agencies and investors it talks about net debt. International agencies such as the International Monetary Fund and the OECD always focus on net debt — they barely mention gross debt.

Moreover, net debt to GDP is what matters. Telling me that your mortgage is $250,000 is not very informative. If you have annual income of a million a year that’s not very much debt. If you make $70,000 a year it’s a lot.

Our net debt to GDP is about 12%. It’s the third lowest in the OECD, where the average is about 50%. It’s lower than Germany, the UK and the US — and lower by a very wide margin.

It’s tempting to call Hockey’s claim that Australia has a debt crisis “fuzzy arithmetic”. It may be fuzzy, but it’s certainly not arithmetic. It’s just wrong.

So, what does this all mean for the Budget next year? Actually, probably not that much. Many of the cost-saving measures come into place (such as the age pension eligibility age) after the likely life of this parliament, let alone next year. The one thing next year will reveal is how the forecasts are looking. We’ll have a better fix on the magic 3.5% GDP growth number.

We should all hope it pans out. Hockey certainly should. He’s wagered his political credibility on it.

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

Tim Harcourt

It’s been a super month for government economic statements in Australia with the long awaited Commission of Audit report being released just ahead of the usual federal Budget unveiling.

The content of the commission’s report was as interesting as its timing, though apart from a bit of unexpected policy freelancing on the minimum wage, it mainly stuck to its brief of addressing expenditure cuts and didn’t touch the revenue side of the Budget.

But what was the reason for the Commission of Audit and federal Budget to be timed together? What was the strategy behind it?

Ironically, the commission’s approach reminded me of the old Builders Labourers Federation (BLF) trade union tactics by putting out a radical wish list of expenditure cuts – like a BLF ambit log of claims – so the federal Government could be seen to bring down a moderate Budget by comparison.

It’s almost a bad cop-good cop routine or, if you like, a rope-a-dope strategy – named after Muhammad Ali’s famous upset win over George Foreman for the heavyweight boxing title in Zaire in 1974.

The strategy goes like this: put out a radical Commission of Audit report to get the opponents and the media throwing punches and by the time you bring down the Budget, the sting has come out of them and the Budget looks meek and mild by comparison.

This is how Ali beat Foreman: getting his opponent to swing all his punches and wear him down. Regardless of the individual merits of the Commission of Audit’s recommendations, it created a flurry of activity and had people talking of overall public sector waste, whether it was true or not on an individual agency basis.

The other part of the strategy has been to float the idea of the “debt levy” to beat the “debt crisis”. Again, the federal government wanted to create an atmosphere of a budget emergency or crisis. And used it to justify a 1% debt levy on taxpayers (deemed to be high-income earners) to help get through the temporary emergency.

But the debt levy makes no economic sense and for several reasons.

First, there is no debt crisis. Australia is not Europe (see my blog, My Big Fat Greek Debt, Explained), we are not America or Argentina (see my blog, Don’t Buy from me … Argentina). The net debt to GDP ratio in Australia is only 11% compared to the OECD average of 50%.

Second, it makes sense for governments to carry some debt. Governments provide the community public goods – defence, border protection, hospitals, education, roads, etc, that can’t be provided by individual firms and households alone. That’s government’s job, and whatever politicians might tell you, the federal Budget is not like your family budget.

There are social returns on public investment that the federal government provides and has done right back to the time of governor Lachlan Macquarie (1810-21) and even before that. Provided the government can service the debt, and get return on its investments in infrastructure with a growth strategy and sustainable and growing export income, it’s a rational and sensible thing to do.

Third, you can’t call a debt levy temporary. It’s not. As my Australian School of Business colleague Richard Holden has pointed out, you can have levies for temporary acts of nature such as a flood or bushfire, but not an open-ended one, especially like the one proposed which simply doesn’t raise enough revenue.

Of course, aside from the shortcomings of the debt levy and the Commission of Audit, there are ways in which governments can structurally change the Budget – such as, taking away high-income super concessions (former treasurer Peter Costello’s Willy Wonka golden ticket to high-income baby boomers); eliminating middle-class welfare (private school subsidies, private healthcare rebate); eliminating some government agency duplication (there are some sensible parts of the Commission of Audit); and reform federal-state relations for the 21st century.

But is there an economic crisis? No, there’s not. Australia’s economic fundamentals are still in good shape. If you look at the most important indicator, the labour market, we are still receiving better than expected news on employment.

The government’s own figures show that the total number of jobs in Australia rose by 14,200 in April to a seasonally adjusted 11.5 million. Inflation is low, wage growth is moderate and even interest rates look like being on hold for a while, and there is now almost a concern they may have to trickle up a little later in the year to clamp down on growth.

Is there a budget crisis? No, there’s not, and there’s certainly no debt crisis despite the atmosphere created by the Commission of Audit and talk of a debt levy.

Tim Harcourt is the J.W. Nevile Fellow in economics at the Australian School of Business and author-host of The Airport Economist.

James Morley

In the mid 1990s, The Wall Street Journal ran an editorial with the headline “Bankrupt Canada”. Ratings agencies had recently downgraded Canadian government debt and the WSJ editorial pondered whether Canada would need to be rescued by the International Monetary Fund.

Soon afterwards, the Liberal government of the day put Canada’s fiscal house in order with deep spending cuts and more mild tax increases. Less than a decade later, Canada’s triple-A rating was restored and today it remains a top fiscal performer with a public debt-to-GDP ratio under 40%, compared to its peak at 68% in 1996.

Jumping across the Pacific and fast-forwarding in time, it would seem that Australia now faces a similar existential debt crisis to Canada’s in the 1990s, at least according to the Liberal government of the day here.

But Australians could be forgiven for wondering “what crisis?” in light of a triple-A rating on government debt and a public debt-to-GDP ratio under 20%.

Indeed, the IMF’s recent country report for Australia explicitly states, “Australia’s modest public debt gives the authorities scope to delay their planned return to surpluses”. Unlike with the Canadian fiscal crisis in the mid 1990s, no mention has been made of Australia needing to be rescued by the IMF.

So what’s going on with all of this talk of a budget crisis? It appears that Prime Minister Tony Abbott and his Treasurer Joe Hockey are suffering from what Nobel prize winner Paul Krugman calls “VSP syndrome”. This label diagnoses a tendency for “very serious people” in policy circles to burnish their economic credentials by proposing tough policies, even when these policies do more harm than good.

Abbott and Hockey clearly want to demonstrate their economic courage by making big cuts to spending in order to save Australia from a debt crisis. The lack of an actual crisis is only a mild inconvenience in this narrative.

Now, other very serious people are going to read this and assume I’m foolishly ignoring the looming demographic crisis faced by all major industrialised economies, with dependency ratios set to balloon in coming decades and our ability to fund social services at currently promised levels becoming increasingly difficult. But I’m not ignoring these long-term problems. At some point, entitlements will have to be cut back.

However, broad cuts to spending now and a temporary crisis levy are not long-term solutions to a demographic crisis. They are simply a way for a government to achieve a temporary surplus at all costs. The temporary nature of the so-called “crisis levy” is as clear an indication as possible that the government’s proposed policies are not really about long-term solutions.

The unemployment rate in Australia has been slowly rising during the past couple of years. Given stable inflation, this has led the Reserve Bank of Australia to cut interest rates and keep them low. But the RBA is no doubt worried about the influence of low interest rates on house prices. In an ideal world, they would like to raise rates back to a more neutral level.

But we are not in an ideal world. Indeed, a manufactured fiscal crisis that produces big spending cuts and a temporary crisis levy (which, for fun, I will resist calling a “tax”) will put pressure on the RBA to keep interest rates lower for longer as they try to help the Australian economy adjust to the post-mining-boom era.

But this loose monetary policy risks increasing imbalances in the housing market, which could lead to a real bona fide financial crisis in the future when house prices stop increasing and household debt becomes more expensive to service.

The real cost of borrowing is unusually low right now. This won’t last forever. And when it ends, it will lead to a difficult period of adjustment for Australians holding a lot of debt tied to short-term interest rates. But the current low real interest rates provide an opportunity for governments to borrow at long maturities to finance public infrastructure.

So if Abbott and Hockey really want to burnish their economic credentials, they should stop wishing there was a Greek-style fiscal crisis to address and instead act on an unusually good opportunity for long-term investment in infrastructure at low real interest rates.

The stimulative effects of this temporary increase in spending would also allow the RBA to return short-term interest rates to a more neutral level and diminish the risk of a future financial crisis based on a housing bubble.

Alas, however, I fear “crisis envy” will carry the day when Hockey delivers the Budget and we will have yet another example of VSP syndrome to point to. It will be an opportunity lost for both fiscal and monetary policy in Australia.

James Morley is associate dean (research) and a professor of economics at the Australian School of Business. A version of this post appeared on The Conversation.

Richard Holden

In the lead-up to Australia’s federal budget on May 13, there have been the usual test balloons floated by the government. Raise the aged-pension eligibility age? A $6 co-pay for GP visits? Cuts to the ABC? And so on.

But the prize for the most “interesting”— and I mean that in the ancient Chinese curse kind of way — is the idea of a “debt levy”.

It’s a little hard to tell exactly what the idea entails since neither the Treasurer nor the Prime Minister will really talk about it, but it seems to be simple enough. Tax those Australians earning over a certain income level a special “one-off” amount and use the proceeds to pay down government debt.

Just like the flood levy and the East Timor levy, right? Actually, no.

The flood and East Timor levies were one-off responses to unusual budgetary shocks — one a natural disaster and the other a geopolitical necessity. They made sense because they dealt with transient fiscal problems. But structural problems require structural solutions— not one-time levies.

When your local surf club has a fire not covered by insurance, it makes sense, painful though it may be, for the members to kick in for the repairs. When the committee says they need a special levy to pay for recurring expenses like petrol for the inflatable rescue boat, there’s a change of committee at the next annual general meeting.

Labor’s response to the proposed levy is as revealing as it is disconcerting. Shadow treasurer Chris Bowen has barely stopped for air in repeating the line: “But they said they wouldn’t raise taxes.” Really, Mr Bowen? That’s your problem with it? You’re OK with bad policy if it’s announced in advance?

I do give the shadow treasurer partial credit for borrowing a line from Ferris Bueller’s Day Off — but he missed the real voodoo in the government’s economics.

First, Australia does not have a debt crisis. Or, to put it another way, Australia does not have a debt crisis. Far from it. Commonwealth net debt is about 11% of GDP, the third lowest in the OECD (the average is 50%), and low by historical standards. Government borrowing rates are at all time lows. Indeed, it was only a few years ago that we were discussing how Australia’s debt being so low was a serious problem because it might lead to the government bond market drying up.

But isn’t all debt bad? I mean, shouldn’t the country live within its means and not spend more than it “earns”?

As Nobel Laureate and New York Times columnist Paul Krugman has pointed out repeatedly: government finances are fundamentally not like personal finances, for multiple reasons. One of them is the huge payback that social investments can deliver.

Government debt levels should typically not be zero. The Commonwealth government can borrow long term at around 5%. The social returns on wise social and infrastructure investments are often more than 15%. Not borrowing at 5% and lending at 15% is to miss huge opportunities.

Governments can invest in projects that we never can as individuals: healthcare, schools, major infrastructure, national defence — and that’s what makes the large returns possible. It is just very different than thinking about maxing out your Visa card to go skiing.

But suppose you don’t believe any of that. The debt levy is still a bad idea. It won’t raise very much money, and it will set a terrible precedent.

Suppose there is a 1% levy on all incomes over A$105,000, for one year — that is, the top 10% of tax payers. This would, by my back-of-the-envelope calculation, yield about $1.9 billion in revenue, all else being equal. That would reduce federal government debt by about three-quarters of 1%. That’s basically a rounding error in the scheme of things. So is it going to be bigger, longer, apply to more tax payers? It gets you thinking …

And there’s the “all else being equal” part, so often overlooked in public discussions about taxes. If announced for the coming year, workers will rationally adjust the amount they work, hence earn, and hence pay in taxes. Economists of all stripes know that labour supply adjusts to taxes. The result would be not only less revenue than might naively be predicted, but slower growth and private spending as well.

Of course, it could be made to apply retroactively to avoid the labour supply issue. And this brings us to precedent. In this respect a debt levy would be truly disastrous.

If it becomes acceptable for governments to simply jack up taxes because they don’t approve of the policies of the previous government, then public confidence will be shaken. It will create a climate of fear and uncertainty that will deter investment in physical and human capital — with potentially severe economic consequences.

One should feel a bit for Hockey. He has got a really bad job. This budget won’t please many people, and it will entail some tricky politics. But it can, at least, be good, grounded in good economics.

When it comes to the debt levy the Treasurer should heed the Reagan mantra. Nancy Reagan, that is, and “Just Say No!”

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

Tim Harcourt

In Australia the car industry is unique. It has unique Australian characteristics and capabilities, and its closure is a self-inflicted wound.
 
The exit of Toyota from Australia really symbolises the way the Australian economy has now moved on from the days when it was a manufacturer, and it now has more of a dependence on the resources sector.

Toyota has confirmed that it will cease all production in Australia by 2017. Approximately 2,500 jobs are expected to be lost when the Japanese car maker closes its Altona plant in Melbourne.

The exit of Toyota is very sad, and really signals the death knell of car making in Australia. In hindsight we should have focused on export orientation and trade promotion, supporting the free trade agreements, and building on our export success in Asia and the Middle East and emerging markets.

When I was on the Bracks Review, I made it clear the government could intervene with tariffs or support, but despite that changes in the global economy are had a huge impact Australian car industry. One crucial issue was until recently the very high Australian dollar which would have wiped out any impact of a tariff freeze and the protectionist lobby would have only had a pyrrhic victory of a few months.

However in the current debate over the future of the industry there are two extremes hogging the limelight. There’s one camp that says protect the industry no matter what the cost – and indeed protect manufacturing at whatever the cost – and there’s another camp that sees it as a badge of honour to say Australia should not produce cars and they belittle any outcomes by the industry to raise international competitiveness. I recall a former Australian ambassador in Washington, loudly and proudly telling an American audience that the optimal number or car companies in Australia is zero. Fortunately, Bracks, like Button before him, eschewed both extremes and advocated a moderate path of reform for the industry.

This steady reform is what we should have had; instead, we had Ford, GM, and now Toyota falling like dominos. If only GM had gone Ford & Toyota might have just hung on. Alas maintenance of manufacturing and the constant changing of promotional gears as global economic and environmental conditions change was very important.

Australia failed – and to hang out the car industry to dry is very sad.

Tim Harcourt is the JW Nevile Fellow in Economics and an adjunct professor in International Business Strategy, at the Australian School of Business, the University of New South Wales.

Tim Harcourt was also an economic adviser to the Bracks Review of Australia’s Automotive Industry.

Geoffrey Garrett

Japan’s Prime Minister Shinzo Abe alarmed Tony Abbott and other world leaders at Davos last week by saying East Asia today reminds him of Europe in 1914. The new government has already been caught in the great power crossfire, with China’s bristling at its apparent pro-Japan, not to mention pro-America tilt.

Abbott’s overall stance is right. But to understand why requires thinking through Abe’s pre-1914 metaphor.

Like China and Japan today, Britain and Germany then were bound by large and mutually beneficial economic links. But win-win economic relations were not enough to stop the continent’s major powers descending into cataclysmic war.

With rising Sino-Japanese tensions in the East China Sea amid still raw historical animosities, is Asia on the edge of a major power confrontation that would inevitably suck other countries into a global war?

Military strategists in Australia and elsewhere are taking the risks very seriously, as they must.

Nonetheless, this nightmare scenario reminds highly unlikely for one: the transformation of America’s global role over the past century.

Put simply, the United States has the power and the interest dramatically to reduce the risk of war breaking out between China and Japan, and to isolate and minimize the consequences of any armed conflict should it ever occur.

China will continue to worry out loud that Australia is too close to the US. But make no mistake that the US remains the ultimate guarantor of peace and stability in East Asia.

Compare the worlds of 1914 and 2014.

Like prewar Britain-Germany, the fact that China and Japan are joined at the economic hip has not quelled high and rising tensions between the world’s second and third biggest economies.

But the global picture is completely different, and most of this has to do with the power and position of the United States.

In 1914, the US was an emerging economy three decades from global dominance. At least as important, America was a largely isolationist power that viewed internecine European wars as far beyond its concern.

More than a century after the revolutionary war, the bonds between Britain and the US had grown very strong. But no one was under any illusion that the US would immediately fight on Britain’s’ side. It clearly would not.

No surprise then that America sat idly on the sidelines of World War I until 1917 amid worries about a German invasion of the US from Mexico and the German sinking of an American ship in the Atlantic.

Also note that economic connections between America and Germany were minimal. The two were rival agricultural powers that had begun developing what would soon be awesome manufacturing might. But they were doing so in splendid isolation. America’s economy did not depend on Germany nor vice versa.

The US was simply disinterested in Europe. The contrast with America and East Asia today could not be greater.

It is an article of faith in the world’s largest economy that the US is the world’s “indispensible” power—there is no major issue in the world in which the US is not interested and for which the US is not needed to resolve.

The hurdle to US boots on the ground in the Middle East today is much higher than it was a decade ago. But Barack Obama’s “rebalance” towards Asia is very real.

Japan is one of America’s key allies, with a large, enduring and highly strategic US military footprint on Japanese soil. The US-Japan alliance would inevitably mean that the US would fight to defend Japan should it be attacked.

Doesn’t this make a doomsday World War III more likely? No, for two reasons

First, the US is not sitting idly by as Sino-Japanese tensions rise. America’s dominant and overpowering interest is in ensuring that armed conflict does not break out, and it is throwing all its diplomatic might behind this effort.

This does not mean that shots—likely accidental or unintended—will never ben fired across the East China Sea. But if they armed conflict occurs, the US will do everything in its power to ensure that the conflict is quickly defused and does not spread.

Second, the real game changer is the US-China economic relationship. Everyone knows about the strategic competition between the world’s top power and the only country that could take its perch.

But the Sino-American economic relationship is the deepest, most complex and biggest bilateral economic relationship in human history. This means China must consider much more than its antipathy for Japan while the US must think about much more than its Japan alliance.

America is China’s number one market, helping to lift hundreds of millions of Chinese out of rural poverty. Chinese government purchases of American Treasury bills keep US interest rates low and the post-GFC recovery strengthening.

For American multinational firms as diverse as Apple, General Motors and Wal-mart, China is not only their biggest supplier but also their biggest and fastest growing market. China in turn welcomes their presence because this gives aspiring Chinese global companies the invaluable chance to learn from and mimic the best.

China-Japan war is simply unthinkable for America, and it has the power in Beijing and Tokyo to make it highly implausible if not impossible.

Abe was narrowly right to draw parallels between China-Japan today and Britain-Germany in 1914. European economic ties did not stop World War I. But Japan’s Prime Minister missed the bigger and more important story at Davos.

A century ago the US was an emerging power happy to sit on the sidelines of European conflict. Today, it is completely enmeshed in East Asia. That remains the best possible news for Australia.

Geoffrey Garrett is dean of the Australian School of Business at UNSW Australia.

Follow Geoffrey Garrett on Twitter: @garrett_geoff .

This Opinion Piece previously appeared in the Singapore Straits Times.

Dale Boccabella

The push from the states to reduce the GST threshold on imported goods is being driven by a desire for a bigger pool of GST revenue and they will get their way, despite the inevitable backlash from consumers.

Australia’s $1,000 GST low value exemption on imported goods is significantly higher than comparable countries such as the UK ($25), Canada ($20), Singapore ($330) or New Zealand ($320). More importantly, the $1,000 threshold is too great a departure from the zero-threshold that applies to consumer purchases from Australian bricks and mortar retailers.

What may further anger consumers is the approach governments take to border security charges and tax collection costs under a lower threshold, given that parcels flowing through the international mail stream into Australia are subject to manual, labour-intensive processes.

Under current law, there are no Customs and Border Protection import charges levied on imported items valued at or below the $1,000 threshold. However, somewhere between $40 and $48 is charged to goods above $1,000. Also, the Department of Agriculture, Fisheries and Forestry levies a $15 charge on items above $1,000 to support its biosecurity obligations.

Julian Lorkin interviews Dale Boccabella from UNSW about the push to reduce the GST threshold on imported goods.

As the 2012 report from the Low Value Parcel Processing Taskforce noted, the present approach to border charges involves cross-subsidies, infringes neutrality and undermines the government’s cost recovery principles. Accordingly, if the government decides to lower the GST threshold (to, say, $300), it will be faced with the decision as to the level of charges (if any) that will apply to the import.

In addition, GST collection costs for the newly taxed items are very likely to be passed on to consumers. The most likely outcome is that the express carriers and Australia Post will be required to collect and remit GST to Customs, and from there, be allowed to recoup these costs from the consumer.

Part of the reason for placing this burden on the express carriers and Australia Post is that goods can be released to consumers from Customs-controlled premises before the GST is collected, thereby allowing for quicker delivery. This would also avoid the need to store “tax unpaid goods” at mail gateways and licensed premises, which already have significant capacity problems.

All up then, a consumer who purchases a $500 item from an overseas supplier could end up paying a lot more – say, $650-$750 – to actually obtain the item. The cost will be even higher if GST is levied on transport and insurance costs, which is currently the case for goods above $1,000.

The question of whether the lower threshold would also apply to customs duty will also need to be addressed, but this would not be a significant cost as most items only have 5% duty on them.

The other political issue involves the timing of a change to a lower threshold. On the one hand, the bricks and mortar retailers and the states would prefer a lower (permanent) threshold implemented as soon as practically possible. But border security agencies such as Customs, as well as the express carriers and Australia Post, would like anywhere between 18 months to three years to implement it properly.

Timing will depend on the time required to upgrade computer systems, and increasing staff numbers to deal with the higher volume requiring manual data capture in the international mail stream, as well as required staffing changes to deal with increased volumes of items requiring GST assessment and collection.

The movement of cargo was severely disrupted and border security compromised during a two-month period when the import component of the Integrated Cargo System was introduced by Customs in 2005. This happened due to the lack of pre-testing of new systems and software, a lack of industry readiness and training, and lack of staged implementation of the change. The government will want to avoid repeating such a failure.

The Taskforce noted three things. First, it would not be practical to just lower the threshold without any system changes and considerable preparation. Second, depending on issues such as who will collect the GST from the Australian consumer – there are a number of options, or a combination of options – and the extent of system changes required, initial reforms could be implemented within two years.

Third, once a decision is made to lower the threshold, reductions in the threshold to its long-term level should take place in stages. This allows all relevant parties to review how the first stage was implemented, and it allows for adjustments to systems in readiness for the extra volume numbers associated with the further reduced threshold.

All this suggests that a lower threshold cannot be introduced very early in the first term of the Abbott Government, even though the prevailing political wisdom is that distasteful reforms need to be introduced very early in the term of a new government.

Further, the desirable staged reduction in the threshold to its ultimate long-term level may push implementation of this reform agenda into a new federal parliamentary term, which raises the prospect that part of the reform would have to run the gauntlet of an election.

Jean Baptiste Colbert once said: “The art of taxation consists in so plucking the goose as to obtain the largest amount of feathers with the least amount of hissing.” The low value import threshold issue is likely to be the Abbott Government’s first real test on “public” tax reform. It is hoped that substantial consumer hissing will not divert it from sound decision-making.

Dale Boccabella is an associate professor of taxation law at the Australian School of Business. Boccabella, and colleague, Kathrin Bain, will present a paper on the GST low value import threshold issue at the January conference of the Australasian Tax Teachers Association in Brisbane, 20-22 January 2014. A version of this post appeared on The Conversation.