Fixing Australia: Do the Econocrats have the Right Answers? (2010)

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Email sent 6/10/10

Michael Stutchbury,
The Australian

Re: Red Book's hard reading for Labor, The Australian, 27/9/10

Your article suggested that the 2010 federal election would have been more meaningful if information contained in the Treasury's 2010 Red Book briefing to the incoming government about Australia's outlook had been available beforehand. Undoubtedly this is so.

The Red Book seems to reflect a more realistic view of Australia's financial and economic challenges than was previously available. But it also arguably advocates policies that are part of Australia's problem. An outline of your article about the Red Book is presented below, together with speculations about the substantive issues. In brief these suggest that:

  • the primarily financial criteria that Treasury rely on in suggesting policy are limited and inadequate;
  • Treasury is unduly pessimistic in suggesting there is no alternative to simply reacting to market forces and accepting the uncomfortable structural changes that these force. Similarly;
  • the concentration of population growth in major existing cities might be efficiently reduced by innovative methods to create market-driven population 'magnets' in some regional centres;
  • infrastructure problems would be worsened by the Red Book's reform suggestions. Rather institutional obstacles need attention (eg federal fiscal imbalances and inappropriate market mechanisms);
  • tax reform proposals need to be based on also seriously considering the tax revenues available to state / local governments, and the differences between economic systems in Western and East Asian societies;
  • putting a price on 'carbon' will not reduce investor uncertainty in affected functions as much as reducing scientific uncertainty would.

Moreover the absence of reliable information as the basis for political debate is not Treasury's fault.

Rather it is a symptom of Australia's Reliance on Luck (eg natural resource wealth, and on copying policy ideas from UK / US / OECD / etc), which has traditionally made civil institutions (eg associations, institutes, universities) believe that it was not necessary for them to provide up-to-date and practical ideas about public policy issues to opinion leaders. Moreover that deficiency is only one of the weakness that are now taking Australia's system of government to the point of failure (see Australia's Governance Crisis and the Need for Nation Building)

John Craig


Outline of Red Book's hard reading for Labor

Treasury's post-election Red Book reveals federal government's tough choices. It reveals 'econocrats' frustration with bipartisan retreat from economic reform. Whereas in 2007 the incoming government could 'buy' difficult reforms because of its budget surplus, such reforms must now be revenue neutral, and this is harder. The mining boom, population growth and climate change all have structural adjustment costs that will hit consumers. However soaring export prices and low unemployment have made reform hard. Issues raised during the election (eg population growth, infrastructure; congestion; cost of living; regional / sectoral disparities; pace of change) are manifestations of structural adjustment. Though adjustments come with costs, markets must be allowed to operate so that true costs flow through (with appropriate social safety nets). Government needs to build consensus on each policy, to get agreement. Economy: If hard budget choices are not made, interest rates will rise. Economy is strong - because of China-fuelled mining boom, and will soon be at capacity. Skill shortages will fuel inflationary pressures. Tighter fiscal policy will be needed to reduce the need for interest rate rises. Budget also needs to be tightened because mining boom made economy more vulnerable to another financial crisis (eg due to double-dip US recession, European sovereign-debt fears, or China relapse). These put very high mineral prices at risk. Low public debt and strong banking system leave Australia well placed to cope with any future financial crisis, but the confidence of international financial markets is also important (eg by maintaining policy credibility). The banking system remains a risk because it relies heavily on offshore borrowing - and heavily indebted households as well as high housing prices further increase vulnerability to economic shocks. Reducing this risk requires further efforts to improve the structural position of budget - probably going further than ALP's existing 2% real growth cap. Population: Labor and Coalition are wrong to pretend population growth can be cut much. Immigration will reduce the budget costs from aging and baby boomers. Projected growth to 36m included allowance for reducing immigration from 300,000 to 180,0000. 2/3 of additional people are likely to settle in cities, because of superior opportunities and services. Regional settlement policies would be expensive and inefficient. Infrastructure: Bigger cites need better housing and transport, and more competition and user-pays for essential infrastructure. The NBN is risky. Population growth has exceeded strategic capabilities of state and local government. They can't develop 'shovel ready' projects, and refuse to make appropriate use of price signals so as to encourage private investment. This has led to serious infrastructure bottlenecks. Heavy trucks should pay for road damage. Congestion charging should be applied in cities. Urban water reforms should be more ambitious - including structural separation of government water monopolies and allowing private competitors to access water, sewage and stormwater systems. The NBN proposal turns Telstra into a retail Telco, but has significant risks. Tax: Tax reform is vital, requiring losers or large budget costs. Henry review called for shift from taxes on business investment and domestic savings to broad-based taxes on less mobile land, resources and consumption. Inefficient state taxes (stamp duties, payroll tax and land tax) should abolished or reformed. Climate Change: Cutting carbon emissions requires pricing carbon. Direct action will cost more. Concerns about ETS's effect on electricity prices are valid, but the cost of unmitigated climate change will be severe, and delaying action would be costly and disruptive (eg by making power generation investment uncertain). Direct action measures (eg carbon sequestration) have problems. A need is also seen to: streamline COAG; make vocational education and training more responsive to industry; increase health co-payments; review self-managed super funds; and look beyond bi-lateral free trade deals. If this information had been available before election, the election process would have been better informed.


Economic / Financial Criteria: An Insufficient Basis for Policy

The proposals in Treasury's Red Book are based on economic considerations which treat financial criteria (eg a balanced budget, enterprise profitability, economic value added, etc) as the primary criteria for policy.

However, though such criteria are valuable, they are also limited - and those limitations need to be considered (see The Advantages and Limitations of Financial Criteria). In brief the latter argues that

  • conventional economics is built on the useful role that finance / money plays as: (a) a means of exchange and a store of value; and (b) in motivating, coordinating and directing economic activities;
  • money also has more fundamental advantages that economics does not conventionally recognise, ie in helping to create a simplified economic environment in which rationality (the preferred means for problem solving in Western societies) can be effective. This is important because the failure of rationality in dealing with complex problems is recognised in many disciplines;
  • there are limits to financial / conventional economic criteria in guiding decisions by individuals, enterprises and public policy analysts. For example: (a) non-economic criteria may also need to be taken into account; (b) some financial techniques can create obstacles to rational decision making; (c) government functions can't be satisfactorily coordinated in terms of financial criteria, and past attempts to improve efficiency by using such methods have been counter-productive; (d) information (which can potentially change the functions that economics analyses) may be a more effective tool for economic management than fiscal or monetary policy; and (e) developing tax policies (eg for the mining industry) on the basis of financial criteria that make sense in a Western economic context can be hazardous in an East Asian economic environment

The limitations of financial criteria as a basis for public policy have significant implications for many of the suggestions Treasury advanced in the 2010 Red Book.

Improving Australia's Strategic Position

Despite strong growth prospects associated with a mining boom (which imply that overheating and regional imbalances will be Australia's major economic problem), Australia now faces risks because of its dependence on that boom and on foreign capital inflows - both of which could be disrupted because of unresolved stresses in international financial systems (see Unstable Environment).

The Red Book's views about Australia's current challenges appear excellent from a financial viewpoint. There is (for example) now official recognition of: (a) the need for difficult action to deal with a structural deficit; (b) the risks of further global financial and economic instability; and (c) the need to consider Australia's credit rating, given heavy reliance on international investors and potential risks such as banks' exposure to property markets [Qualification].

However the Red Book seems much weaker in relation to current 'real economy' challenges (eg in relation to the mining boom, adverse impacts on other sectors and on some regions, potential skill shortages, population growth, infrastructure needs).

Treasury assumes that nothing can be done except react to market forces and tolerate the adjustment stresses they generate. However this is overly simplistic. For example a systematic process of 'nation building' could include the empowerment of business / community leaders to take effective initiatives to accelerate market-focused change in economic systems as a whole.

Recent attention has been drawn to the ability that East Asian economies have exhibited to change the nature of the market signals that they respond to (eg consider sources referenced in Correcting a Few Misconceptions). The latter argues that: (a) economic 'miracles' in East Asia have been based on the assumption that economic outcomes are not determined by any inevitable economic logic; and (b) the methods used are based on traditions that are alien to Australia's heritage and have serious limitations. However, over two decades ago methods were trialled in Queensland that could probably have achieved similar outcomes (in terms of accelerating change in the real economy in advantageous directions) while being compatible with Australia's institutions and while avoiding the limitations faced in East Asia.

Australia's current economic risks are serious because efforts to diversify its traditionally commodity-dependent economy since the 1980s have been unsuccessful and the economy remains relatively under-developed. The official approach to economic reform has been unbalanced. Emphasis has been placed on promoting competition, but this was not balanced by efforts to reduce systemic obstacles to competing successfully in high productivity activities (see Lifting Productivity: Considering the Bigger Picture). The latter includes suggestions about how the productivity and competitiveness of the real economy might be enhanced. Methods suggested might (for example) be used to: (a) diversify the economy and reduce dependence on mining exports and the 'Dutch Disease' difficulties facing other industries and some regional economies; (b) create institutions for workforce training that are responsive to industry needs; and (c) identify options for, and stimulate commercial initiative to provide, high-speed broadband access across Australia.

Population Growth

There is little doubt that the Red Book is correct in suggesting that Australia's population will probably grow to the levels that Treasury has previously suggested. However:

Overcoming Infrastructure Inadequacies

The Red Book is correct in identifying Australia's infrastructure deficiencies, but inadequate in suggesting how that problem could best be overcome (eg see Infrastructure Constraints on Australia's Economy, 2005).

For example, while infrastructure certainly exceeds the capacity of states and local authorities, this deficiency is arguably due to:

  • the distortion of their operations by the perceived need for federal government involvement that results from the extreme fiscal imbalances that have come to characterise Australia's federal system (see Federal State Fiscal Imbalances). Centralisation of planning and control makes no more sense for infrastructure (which often involves the capital component of various state and local government functions) than it does for other economic activities (see The Secret of Failure: Claim Wisdom Without Practical Realism); and
  • the erosion of public officials' knowledge and skill base through 'reforms' aimed at increasing political responsiveness and increasing efficiency through the use of 'business-like' methods in undertaking governments' non-business-like functions (see Decay of Australian Public Administration, 2002).

Likewise the assumption that even more competition, price signals and private investment would be effective in future in coordinating functions that suffer real market failures is likely to be counter-productive (see again Infrastructure Constraints on Australia's Economy, 2005).

As the latter implies the (artificial) obstacles that have been created to the development of infrastructure might be be overcome by a serious approach to 'nation building' (see also A Nation Building Agenda).

Tax Reform

Tax reform is very complex. However the reform agenda canvassed by the Henry review (which the Red Book has re-emphasised) is not a sufficient basis for this because:

  • effective provision of public goods and services is unlikely to be achieved without attention to the fiscal imbalances that cripple Australia's federal system (see Vertical fiscal imbalance). There is much more to be gained by enabling state and local governments to operate effectively, than by centralised efforts to optimize resource allocation;
  • changes in the sources of tax revenues available to states seem necessary to motivate them to take development of productive modern regional economies more seriously (see Economic development incentives);
  • changes to taxes on mineral resources may put revenue from this source at risk, if account is not taken of difference between East Asia and Western systems of political economy (see RSPT Won't Hurt Miners: But Pity Help Naive Australians )

Climate Change

The suggestion in the Red Book that putting a price on 'carbon' would increase investor certainty seems most unlikely to be correct, as real certainty can't be achieved until serious efforts are made to reduce the scientific uncertainty about the link between greenhouse gas emissions and climate change (see Carbon Certainty is a Long Way Off).

Other Accounts Other Accounts

Other observers' accounts of the 2010 Treasury Red Book are outlined below, together with comments as appropriate

Treasury Red Book briefing is a blueprint for the policies Australia must embrace if it wants to maintain growth of real incomes. Australia faces the biggest minerals and energy boom since the late 19th century - which offers an extraordinary increase in prosperity if Australia rises to the challenges (inflation, structural change, income volatility). Australia emerged from recession with full employment. There is no room for government spending to sugar-coat reforms and no room for a loss of labour market flexibility. In 2007 reforms could be purchased. but now must be revenue neutral. Rudd government health reforms supposedly were purchased from states, but still require intense federal efforts - as with anything where states are involved. Mining boom will bring structural changes - and crowd out other sectors who lose competitiveness due to high $A (eg manufacturing, services like tourism and education). Government can't intervene intervene on behalf of contracting industries without impeding economic growth. Pressure on them can be reduced by tigher fiscal policy to keep inflation / interest rates low. Strong growth in labour force would ease labour market pressure on manufacturing and services - but requires rapid migration and population growth. If anti-migration lobby can't be contained welfae recipients will need to be pushed into labour market. Other challenges include: restricting spending; tax summit; and greenhouse policy   (Mitchell A., 'The Red Book challenge', AFR, 29/9/10)