But with drivers of growth over the past 25 years unlikely to be the engines of growth in coming decades, now is not a time for complacency. And if there’s one lesson from Britain’s decision to leave the EU, it’s that that disruptive forces are sweeping through the global economy. Australia, with its cohesive politics and economic success, has been able to avoid the worst of these problems, but the dangers are present if the economic challenges are not met.

To start with, the impacts of the reforms of the 1980s and 1990s are fading. The investment boom in mining is over, and the prices for mining and agricultural exports will probably remain subdued with slower growth in China. While Australia’s incomes were boosted by the improved terms of trade, this has partially reversed. The housing boom will inevitably eventually slow.

As evidenced by the results of the Brexit referendum, there is a distrust of the political and economic elites that have led the world’s biggest economies. Disruptive, rapid changes in technology have not led to broad-based productivity growth. Workers in many countries have been left with stagnant incomes and governments with rising public debt.

Industry policy has a bad name among American economists who see it as a manifestation of “capture” where special interests are able to obtain subsidies from taxpayers or special protections that are not in the national interest. The modern theory of industry policy, however, recognises that a well-designed policy can actually help markets work better, therefore helping an economy like Australia’s make the transition to a new growth path when faced with changing economic conditions. Productivity is the key to high growth and rising incomes – and well-designed industry policy can help.

Structure of trade competitiveness

Take, for example, Australia’s manufacturing sector. Mostly because of comparative advantage, it is the smallest among all advanced economies relative to the size of its economy. In 2010, Germany had 21.2 per cent of its workforce in manufacturing while Australia’s was 8.9 per cent. While it’s not surprising that Australia’s structure of trade competitiveness differs from Germany’s because of its enormous export strength of mining and agriculture, it will benefit by taking advantage of its highly skilled workforce and the potential to develop industries based on this human capital – including advanced manufacturing industries.

One of the traditional strengths of the American economy is the close link that exists between leading universities and businesses – an area Australian policymakers are seeking to improve upon. At MIT and Stanford, professors of engineering, biology, finance or economics finish their lectures and head off to the companies they run or advise. They often enlist graduate or undergraduate students to help them with their commercial projects and these collaborations often result in jobs as well as experience. There is a danger in this model if pure research loses out to business interests, but the interaction between academia and the practical needs of companies can largely improve both research and business profitability. It’s worth recalling that even the giants of science in the 18th century were motivated by the need to improve navigation or build new machines or design buildings. Funding for research should support greater industry-university cooperation as highlighted by the Watt Review.

Another important element in Australia’s continued economic success is the growth of its service industries. With most jobs in these industries, the performance and productivity of services will be the largest determinant of Australia’s living standards. Productivity comparisons between Australia and the United States show that Australian productivity lagged behind the US as recently as the mid-1990s, but there has since been substantial catch-up taking place. Smart regulation that promotes competition and rewards innovation are necessary to bring up the laggards. While there is a continuing debate about the possible end of productivity growth in advanced economies, Australia can still do much to catch up to global best practice.

The winners of this weekend’s election will be charged with answering an important question: what is the role of government in a modern economy? How they answer that will determine future prosperity for all Australians.

High taxes, large government, poorly regulated markets (particularly labour markets), excessive debt and poor infrastructure undermine the drivers of growth. The realities of a fragile global economy and the need to build a solid foundation to generate productivity growth in Australia must be at the core of the policies that follow this election campaign.

Martin Baily is a senior fellow at the Brookings Institution in Washington and a former chair of the US President’s Council of Economic Advisers. He has been invited by the Australian Ministry of Industry Innovation and Science to report on lessons from the US for policies to enhance economic growth, innovation and competitiveness.

Warwick McKibbin AO, is the director of the Centre for Applied Macroeconomic Analysis in the ANU Crawford School of Public Policy and is a non-resident senior fellow at the Brookings Institution.

Editor’s note: this opinion first appeared in Australian Financial Review.

      

 

 

The interest rate usually observed in financial markets is a nominal interest rate. The nominal interest rate has two components:  the real rate of interest plus the expected rate of inflation. The real interest rate at the global level is driven by equilibrating global savings with global investment. Historically negative real interest rates have occurred periodically when global savings exceeded global investment and the real interest rate fell to equilibrate savings and investment.

Real interest rates are falling today because savings are high and investment is low globally. Long term real interest rates are low, presumably because this lack of investment relative to savings is expected to last for many years.

The short term nominal interest rate (policy rate) is usually set by a central bank to control macroeconomic targets.  The short term real interest rate is this policy rate less expected inflation in the short term.  The real interest rate is thought to have a larger impact on the economy than the nominal interest rate.  With weak demand, reducing the real interest rate is the actual goal of monetary policy. This can be done by cutting the policy rate or raising expected inflation.

The longer term nominal interest rate is the real interest rate expected over the long term plus the long term expected inflation rate.  It is difficult for a Central bank to control longer term nominal interest rates because the real interest rate is driven by long term savings and investment. Central banks can only have some impact either through changing inflation expectations or by distorting the bond market by buying large quantities of bonds. This latter policy is the basis of Quantitative easing (QE).

Why are some nominal interest rates going negative? Central banks and governments responded to the 2009 financial crisis with unprecedented monetary and fiscal stimulus. Rather than allowing balance sheets to contract and a collapse of the economy, adjustment was postponed. However the problems from the 2009 crisis have not miraculously disappeared due to the actions of gifted policy makers. After seven years there is more fragility today in the global economy than before the 2009 crisis.  Instead of solving the problems in the global economy the policy responses have sown the seeds of the next major crisis. This is not the fault of central banks – they have responded by smoothing the cycle to give time for other policies to be implemented and to produce a sustainable recovery. The problem is with governments who have not implemented the necessary policies to raise productivity growth and they have worsened fiscal overhangs.

The macroeconomic logic of the policy response has been clear. To avoid a great depression demand needed to be generated by loose monetary policy and a rise in government spending financed by debt. The problem with excessive government debt that has not created productive assets is that at some stage someone has to pay taxes to service the debt and ultimately bring it back to sustainable levels. This increases uncertainty about the after tax expected return on investments and therefore causes investment to fall. Thus in a world of falling productivity and slower population growth due to demographics, global savings will rise and global investment will fall driving down the real interest rate.  As demand growth falls, inflation also begins to fall and expectation of lower inflation also drives down longer term bond rates.  Government debt above reasonable thresholds further dampens investment and drives the risk adjusted real interest rate negative. Risk begins to rise.

Once short term interest rates hit zero, many countries started QE which involves buying assets in private markets to further boost asset prices. In a normal world financial prices should reflect some underlying real activity. For example, the value of a share in a company should reflect the expected future dividend stream of the company discounted at the interest rate.

Unless QE results in a rise in real underlying economic activities, the high value of assets (equities, commodities, houses etc) are only driven by artificial demand from central banks rather than fundamental returns. There may be a temporary positive wealth effect through rising asset prices but this is an illusion.

When QE did not have the desired results of raising economic activity and raising inflation some central banks implemented negative interest rates. Banks holding excess reserves at the central bank now have to pay for the privilege rather than earning interest on these reserves. This should force banks to lend those excess reserves to raise economic activity. The problem is that if no one wants to borrow then the banks cannot lend.  The additional problem with negative interest rates is that they also potentially have significantly negative effects on confidence which undermines the purpose of the policy.

Seven years after the financial crisis many markets have been severely distorted both by ultra-loose monetary policy and through a massive build- up of government debt and also private debt in a number of countries (particularly emerging economies).  Australia is in a better position than most but will still experience the global consequences.

The current problems can only be resolved through globally coordinated policies that raise real economic activity through productivity growth and removal of barriers to trade. There also needs to be an orderly deleveraging of stressed balance sheets and a rebalancing of the fiscal accounts of excessively indebted economies. The sooner this process begins the better for the global economy.

Editor’s note: This piece originally appeared in The Australian Financial Review. 

      

 

 

Over the last decade, China has adopted measures to lower the energy and carbon intensity of its economy, partly in response to worsening local air pollution from energy generation. At the 21st Conference of the Parties (COP) to the United Nations Framework on Climate Change (UNFCCC), held in Paris in late 2015, China committed to furthering its efforts by affirming its previously announced goal to cause its emissions to peak around 2030 and to increase the share of non-fossil fuels in its primary energy consumption to around 20 percent by the same year. 

China’s intended nationally-determined contribution (INDC) to the Paris accord also puts forward two new goals for 2030: reducing China’s CO2 emissions per unit of GDP (known as its carbon intensity) by 60 to 65 percent relative to 2005 levels, and increasing the volume of its forest carbon stock by around 4.5 billion cubic meters from 2005 levels.

In a new paper titled China’s carbon future: A model-based analysis, Warwick J. McKibbin, Adele C. Morris, Peter J. Wilcoxen, and Weifeng Liu model the policies China could adopt to achieve its energy-related INDC commitments with an eye to understanding how the policies could affect both the Chinese and global economies. 

The model

In the analysis, the authors use an updated version of the G-Cubed model, a global intertemporal computable general equilibrium (CGE) model, to explore the possible effects of emissions control policies on the Chinese macroeconomy, individual industrial sectors in China, and other outcomes, such as trade flows, currency values, emissions levels, and economic activity. 

The major innovation in the version of the G-Cubed model used in this paper is a significant disaggregation of electricity generation technologies with a focus on non-fossil fuel technologies.

Findings 

The results of the authors’ analysis show that illustrative policies to achieve China’s commitment to cause its emissions to peak in 2030 imply a substantial departure from baseline emissions, even after accounting for large baseline reductions in China’s emissions intensity. 

In the scenarios, Chinese emissions are 6 percent lower than baseline in 2020, 26 percent lower in 2040 and 33 percent lower by 2050. The reductions come at a cost; in 2030 in the policy scenarios, China’s real GDP would be about 1.5 percent lower than baseline, and real wages would grow less rapidly than they otherwise would have. At the same time, the target appears quite credible: the changes to peak emissions in 2030 are manageable for a country that will be growing rapidly in the coming decades and do not involve disruptions that would be likely to cause the commitment to be abandoned.

The authors also find that China’s policies to control emissions have little effect on emissions elsewhere; there is almost no shift in emissions from China to its trade partners. There are, however, small reductions in real GDP in other countries as China’s economy grows more slowly than under the baseline. Those changes are most important for Eastern Europe and the Former Soviet Union and OPEC, and are very small for Europe and the United States. Thus the authors find that countries that import energy-intensive goods from China would bear little of the burden of Chinese emissions control efforts.

You can download the full paper here.

      

 

 

The global financial crisis followed a period of ultra low interest rates in the US from 2001 to 2004 in response to the bursting on the Dotcom bubble and the crash in US high tech stocks. By the time the Fed started raising interest rates from June 2004 until June 2006, there were many problems generated by the long period of loose monetary policy. These included significant over-building and over-pricing of US housing and other financial assets. There was also the creation of various financial derivatives aimed at generating high return in a low return economy, as well as important regulatory changes. The mis-pricing of risk and misallocation of capital over this earlier period carries many lessons as the Fed deliberates on current policy for the US economy.

A strong case can be made that the US economy is close – if not at – full employment. Inflation is well within the Fed ‘s comfort zone. The US economy is looking in good shape and well able to handle a return to higher interest rates. How high a “normal” interest rate might be in today’s US economy is an open question. With low productivity growth, the new normal might be a real interest rate closer to 2%. With inflation running at 1-2% this suggests an interest rate around 3 to 4%. This is lower than historical experience but well above the current zero federal Funds Rate.

The real issue facing the Fed is whether to wait until there is sign of rising inflation and then repeat the 2004 to 2007 experience of chasing a rising inflation rate. The alternative is to act in anticipation of inflation rising over the coming year. The correct strategy is not unambiguous but my view is that the Fed should err on the side of a 25 basis point rise at the current meeting.

A very important consideration is the uncertainty that current Fed policy is generating in global asset markets. No-one is sure what will happen when the Fed raises rates from zero and there is no previous experience of this. The uncertainty is weighing heavily on investment and confidence globally. This could be resolved with a clear announcement of a path for interest rates over the coming year including a rise this week. Waiting longer risks the possibility that there could be a high wage cost outcome in coming months that is not anticipated by the Fed. This would dangerously undermine confidence.

The Fed had no choice but to cut rates to zero to save the US financial system from collapse. It has carefully managed expectations of policy over the past 5 years and has already telegraphed its policy goal. It is time to act and reduce uncertainty generated by speculation of when rates may rise. If a 25 basis point rise in the federal funds rate causes the chaos that many Keynesian commentators argue, then the US economy is in a much more perilous position than even the pessimists believe.

The big problem is not what the Fed policy will do to the US economy. The biggest concerns are the implications for emerging market economies, particularly those with high public and private debt. For more than half a decade, they have been awash with liquidity and the drying up of this liquidity clearly poses challenges for these economies.

The World Bank and IMF have highlighted the global risks associated with rising US interest rates. However the Fed should be focused on what is best for the US economy. Fortunately in this case, a change in US policy would, over time, be of benefit to all countries. Reduced global uncertainty will benefit many countries currently experiencing significant asset price volatility. If some emerging countries experience a crisis as a result of 25 basis points this week, they would have do so whether the Fed raises interest either this month or in December.

Editor’s Note: This post originally appeared on The Australian Financial Review

      

 

 

Both reports are based on a global economic model. The results in these reports should be treated very cautiously because of the enormous uncertainty involved. The outcomes for the consequences of any particular emission target depend on many factors such as the particular model used, the future projections of the world economy which would occur without the imposition of a carbon target and the nature of the policies that are actually used to reach any given emissions targets. The usefulness of applying a well-documented and transparent model to evaluate policies is that the assumptions are clear and the key sensitivities in the analysis can be explored to get a better idea of the range of possible costs for a given target. It is easy to argue that a policy would devastate an economy or would be costless, but a model based exercise forces the analyst to be explicit in the assumptions that are required to generate these alternative worlds. Models can easily be criticized but the alternative is worse, a good deal more flexible and very popular with extreme proponents in any debate.

The first report explored the impact on the global economy if all major countries (except Australia) achieved the targets they have pledged, either with the policies they proposed or with a reasonably efficient policy in lieu of an actual policy announcement. Many countries have pledged energy efficiency improvements which in many cases appears to be a “free lunch”. Someone has to pay for improvement in energy efficiency and this was explicitly taken into account in the modeling. The focus of the report was what impact this would have on the global and Australian economies and key sectors by 2030.

It is no surprise that fossil fuel industries in Australia were most affected with coal bearing the largest costs. Coal exports by 2030 are estimate to be about 7.8% lower than otherwise and coal production in Australia 8.3% lower (although still higher than 2015 levels). Exports of non-fossil fuels sectors are projected to rise, as a weaker Australian dollar would make these other sectors more competitive in global markets. Overall Australian GDP would be roughly 0.16% lower than otherwise by 2030 – or if the absence of an Australian policy response increased the risk in the energy sector, this loss might be doubled.

The second study considered four alternative emission targets for Australia: reductions of 13%, 26%, 35% and 45% relative to 2005 emissions. Also considered were the costs of alternative energy options in electricity generation and the impact of access to international credits.

In considering the impact on overall GDP, there are at least three different ways of measuring these impacts. Commentators have chosen whichever measure suits their argument. You can compare the level of GDP lost in 2030 relative to what would have been without the Paris commitments. GDP is 0.6% lower than it would otherwise be in 2030. This translates into a GDP loss in 2030 of around $20 billion. You can also calculate the sum of GDP lost each year until 2030 to get a cumulative GDP loss by 2030 which is close to $200 billion. If you calculate the impact on the average growth rate from 2015 to 2030 then the rate of economic growth is roughly 0.01% lower. All of these figures mean the same thing when scaled by the appropriate metric. Whether this is a large or a small cost is in the eyes of the reader.

Another lesson from the analysis is that if international permits are available and if they are as cheap as they are today (the assumption of the modeling) then this cost might be reduced by 50%. If the cost of international permits where higher than the cost of reducing carbon domestically then none would be used and the economic costs would be unchanged by this option. If technology costs are cheaper than expected then this figure might also be reduced but if they are higher then this cost would rise. There is a wide range of uncertainty on the economic costs just as there is a wide range of uncertainty over the impact of carbon emissions on temperatures.

In summary, the report finds that Australia’s target of 26% to 28% below 2005 emissions, when compared to other countries in terms of economic costs, is at the high end of the commitments made by all countries for Paris. The extent of effort is better measured by the economic costs than the size of the target. The size of the global target is important for climate change but an equal allocation across countries is not a measure of effort. It is a political measure used for political purposes.

In aggregate, it is reasonable to argue that the Paris commitments by all countries are not sufficient to meet the reductions estimated by many climate scientists that are needed to avoid two degrees of warming. However to argue that Australia is not making a large contribution to the overall effort for Paris is incorrect. Only focusing on the emissions target is playing politics. Until the economic costs relative to the environmental benefits are at the core of the global response, there will not be an effective global agreement.

Editor’s Note: This op-ed originally appeared in The Australian Financial Review

      

 

 

We choose these two approaches because they resemble two key options facing policymakers: continue implementing a performance standard approach under the Clean Air Act or adopt an excise tax on the carbon content of fossil fuels instead. Our goal is to highlight the important high-level differences in these basic approaches, abstracting from the details of specific policy proposals. We explore a wide variety of the illustrative policies’ economic outcomes including: changes in capital stocks and electricity production across eight types of generators, changes in end-user electricity prices, changes in gross domestic product (GDP), overall welfare impacts on the household sector and, finally, one outcome represented in the G-Cubed model and few others: short to medium-run changes in aggregate employment.

We find that a national tradable performance standard (TPS) of the ambition reflected in EPA’s draft Clean Power Plan (CPP) could achieve a significant reduction in future economy-wide emissions relative to business as usual, and would stabilize emissions from electricity generation through 2030 with only a very small reduction in GDP. A carbon tax on fuel purchased by the electric sector would have a similarly small effect on GDP but would be slightly more efficient.

While both policies would have similar and relatively modest effects on the economy as a whole, they have markedly different effects on the electricity generation sector. For an equivalent effect on electric sector emissions, a TPS produces a significantly larger shift to non-fossil generation as a result of the large credit payments it induces between the fossil and non-fossil generating sectors. However, a carbon tax, which shifts some revenue to households through the tax system, produces a slightly better economy-wide outcome as measured by equivalent variation. Both policies cause a variety of reallocations of investment and employment between the clean energy sectors and the rest of the economy.

Finally, it is important to note that many of our key results are robust to wide variations in the assumed elasticity of substitution between different generation technologies. Effects on electricity prices, overall GDP, employment and welfare are modest and change little in response to changes in the elasticity. However, some results are more sensitive: as it becomes easier to substitute between energy generation technologies (particularly between fossil and non-fossil technologies), the price of a TPS credit falls, as does the size of the carbon tax, and the many of the outcomes under the two policies tend to converge. On the other hand, as it becomes more difficult to substitute generation technologies, the differences between the TPS and the carbon tax become larger, as does the efficiency advantage of the carbon tax.

1. See McKibbin and Wilcoxen (2013).  The version in this paper is 124e.

      

 

 

Countries, including Australia, are busily announcing or evaluating the targets for carbon dioxide emissions to be part of these negotiations. As someone who has been modeling climate policy issues for more than two decades, at this time of year I am usually asked two questions: what target should a particular country take and what will be the outcome of the annual UNFCCC negotiations?

The answer to the second question is the same every year – there will not be an effective agreement until the negotiations focus on the right issues. Since the Berlin Mandate, which was the outcome of the first COP held in Berlin in 1995, the negotiations have been around legally binding targets and timetables for reduction of carbon emissions. This lead to the approach of the Kyoto Protocol (COP3) in 1997, which entered into force in 2005. The United States (at the time the world’s largest emitter) did not ratify and China (now the world’s largest emitter ratified but did not take on any targets). Australia ratified in December 2007 just as the Protocol was clearly failing to achieve its goals. Good politics but bad policy, seem to dominate the climate debate in many countries.

The approach of legally binding targets and timetables has not worked in addressing the climate issue. It was thankfully redirected in Copenhagen in 2009 when the threat of failure caused negotiations to finally switch away from legally binding targets to a focus on policies to reduce emissions across all countries. This redirection was encouraging and meant that effective action might eventually emerge. However for some reason, the fixation with targets and timetables has re-emerged for the Paris meeting. The justification appears to be that “this time is different”.

The core problem in climate policy design is that the costs and benefits of taking action are highly uncertain and have very different time dimensions. Costs are incurred in the short term while benefits are likely to be many decades into the future. It is possible to use sophisticated computer models to calculate likely scenarios about the future and calculate a range of potential costs of a given target for a particular country. Using models this way can better inform policy design. But even if the model is 100% accurate, it is not possible to know with any certainty about the assumptions about the future that are fed into these models. The cost of any particular target depends on a very wide range of issues such as: the future evolution of the world economy; the extent to which technologies might evolve to reduce emissions; the cost of these technologies; the nature of the policy designs; the behavior of households and companies and the policies of other countries, just to mention a small subset. Thus it is not possible to know with any precision what target a country should adopt until an attempt is made to achieve that target and the actual costs are revealed. Policy needs to be designed to be flexible so it can adapt to information about actual costs and benefits over time. Two equivalent targets could be achieved with very different costs.

Politicians appear to prefer expensive policies that hide who actually pays for carbon policy, relative to low cost policies that make it clear who is paying. There are always going to be winners and losers in a policy change as transformational as climate policy. Whether it is a “cash for clunkers” high emission vehicle buyback campaign or direct regulatory control in particular sectors, it seems costly policies are preferred to the direct pricing of carbon.

Targets for concentrations at the global level are important to guide policy design and are useful for national policy design but ultimately how much each country will contribute cannot be known from a particular set of targets. A target is not a measure of degree of commitment nor does a comparison of targets mean anything about “comparable action”. The focus has to be on creating clear transparent policies within each economy that enable emissions reduction at low cost and which encourage a long term global transformation of energy systems. This can be achieved through markets with clear future carbon prices, in order to drive investment and deployment of new technologies in the way energy is produced and used.

Given the uncertainty in climate policy, there is a strong case that Australia should not take on a legally binding target for emissions in Paris, but it should take on a legally binding commitment to contribute to a global reduction effort in a way that caps the relative costs contributed across countries. Paris is again a crossroads for the UNFCCC process. It will not produce the agreement the world needs while the focus is on the issue of targets and timetables, without also explicitly taking into account the relative costs of contributing to the global effort.

      

 

 

The 2015 Australian budget is a political budget which postpones the medium term fiscal adjustment that the Australian economy needs. It is a reflection of the state of Australian politics today. It is easy to argue that the Treasurer had no choice but to come up with a reasonable budget, given clear political constraints. The federal budget does little economic damage and has some good aspects especially for small business which is a key driver of growth in the Australian economy. But like Labor budgets in previous years, this budget takes a big bet on a future that might not eventuate. Labor lost that bet every year to leave Australia with a problematic fiscal legacy. There is every chance that this budget will expose Australia even more to the many risks in the global economy.

Rather than focus on the winners and losers which is what a political budget encourages, the budget should be evaluated relative to the type of fiscal policy that Australia needs to sustain economic growth and maintain social cohesion.

Australia is an economy exposed to fluctuations in commodity prices, dependent on access to global markets to fund capital accumulation and exposed to countries such as China and Japan which are going through large policy experiments. Uncertainty damages economic growth because it reduces investment. Global uncertainty is high. A core role of government is not to increase this uncertainty and where possible to enable individuals to manage uncertainty when markets fail to do so.

One aspect of good fiscal design is that core spending programs should be based on a robust revenue stream. Otherwise, sharp movements in revenue will lead to ad-hoc shifts in spending programs or taxation arrangements that increase uncertainty in the economy. There is a strong case for a period of surprise revenue increases to be allocated to a Sovereign Wealth Fund that can be drawn down in periods of sharp revenue slowdowns. In this way uncertainty in government policies can be reduced. The big problem Australia now faces is that revenue from the terms of trade boom was locked into government outlays in a way that has been politically difficult to remove when the revenue base proved temporary.

Other important aspects of fiscal policy relate to: the level of debt; the level of taxation and the distortions caused by particular taxes; the amount of government spending and the distortions to incentives caused by spending programs. These need to be addressed as part of a comprehensive reform but were barely touched in this budget.

The scale of government debt is important but in the context of what that debt has been used to purchase. If the debt is used for consumption then someone has to pay future taxes to service this debt. If it is used for investment in infrastructure that earns a real rate of return then the debt is self-financing with no future tax liabilities. Abstracting from the Future Fund which is an asset already netted against some pension liabilities, Australian government debt is still rising rapidly. Because most of the existing debt was not used for investment, it needs to be serviced from future taxes. This budget nudges the path of debt towards a more sustainable level. The level of gross debt at around 26.3% is low by world standards but it continues to rise more rapidly than elsewhere and is high for a country that is as exposed to global volatility as Australia.

Different types of taxes have different costs per unit of revenue and change incentives differently. Taxation needs to shift from taxes on work effort and innovation to taxes on consumption. Moving away from income based taxes to consumption based taxes reduce the economic inefficiency of the tax system. This implies more revenue would be available for redistribution through the transfer systems to compensate low income households. High income individuals can define income away – PAYE taxpayers cannot. Most of the increase in revenue in this budget comes from bracket creep on middle income tax payers. This burden needs to be addressed.

Another argument for moving to consumption taxes to finance core spending programs is they are less volatile than corporate tax revenue. By all means tax highly volatile income streams but this revenue should largely go into a Sovereign Wealth Fund that can smooth the revenue cycle rather than having government outlays vary on a yearly basis in an uncoordinated fashion. Introducing different tax rates based on company size introduced additional distortions. Simplicity of the tax system and efficiency of taxes are important. Fairness is more easily funded through the transfer system with a more efficient tax system generating revenue.

This budget probably does not make the current problems facing Australia any worse. It also does not make important strides in tackling those significant problems head on. A future government will likely be forced to do what is needed. Unfortunately this will most likely be in circumstances that are far less favorable than today. Good economic policy is about minimizing risks in the economy. The problem Australia faces is how to encourage investment. Uncertainty is bad for investment. The key question is whether the short term incentives for greater risk taking in an economy with excessive public and household debt will be more than offset by the failure to tackle the economic risks that Australia faces. It might work, but it is another role of the dice for the Australian economy.

      

 

 

Most of the electorate and much of the Opposition and minor parties appear happy to stay with the status quo. The government is being dragged into accepting the same. It is hard to win votes on a platform of change and there is no doubt that while there will be substantial gains in the longer run, there will be losers in the short run. The problem is the choice of the status quo is not an option except at enormous cost to future generations of Australians. The world is changing and Australia can either be part of an exciting era of global transformation or Australia can descend into decades of high unemployment and economic, social and environmental dislocation.

Since the early 1990s the world has been transformed by the emergence of large developing countries into the global economy. Through a process of reform, China, India and other emerging countries have added billions of workers and consumers into the global economy. This transformation built momentum during the following two decades and now less than half of global production occurs in the advanced economies. Global economic growth over the past few years has almost completely been driven by growth in the emerging world. Many of the advanced economies are mired in recession and high unemployment.  The global economy is changing quickly.

Australia has been surprisingly resilient during this period of global change. In advanced economies, low skilled workers have needed to compete with very cheap low skilled labor in emerging economies. While on the one hand, highly competitive companies (particularly in manufacturing) in the emerging world have undermined the competiveness of industries in advanced economies, they have also lead to an acceleration of technology. Wealth generation through international trade has accelerated during this period. Global poverty has fallen sharply. However the response in many advanced countries has been to try and preserve the status quo through a wide range of badly designed policies including subsidies to declining industries. Another mistake has been the use of aggregate demand management in response to a structural shock. This policy has driven interest rates to zero, public debt to unsustainable levels and high rate of unemployment in many advanced economies.

Australia was subject to the same global forces undermining existing global industrial structures but the major difference was that Australia produced key inputs that emerging countries, particularly China, needed to sustain high levels of economic growth. The income generated in Australia from the boom in China temporarily disguised the nature of the shock Australia faced and enabled successive Australian governments to avoid making the hard decisions on structural adjustment. The idea that fiscal policy saved Australia from the great recession enveloping the world in 2008 is clearly not supported by the fact that most other countries using fiscal policy did not avoid the structural shock. The income gain from China was clearly the most important contributor to Australia’s performance. Labor appears to cling to the fallacy that adroit fiscal policy explains Australia’s success. Despite uninformed commentary that China stopped growing during the crisis, the truth is that China continued to grow above 10% per year during the crisis years from 2008 to 2010. The continued belief in Labor’s fiscal miracle appears to underlie the reluctance of current Labor leaders to acknowledge the extent of the multiple problems Australia actually faces. Not only is Australia suffering the end of the commodity boom but it still has to deal with the structural shock that the rest of the world has been failing to grapple with for nearly two decades.

The recently published Inter-Generational Report (IGR) doesn’t quite get this broader global context correct. The focus on the demographic and budgetary issues should have been couched in a global context of major intergenerational and international change. The IGR is correct that demographics and the current reliance of outlays in excess of revenue sources is important but that is not Australia’s biggest problem nor is there where Australia’s opportunities are to be found. It is critical to get the fiscal problems addressed but the issues are much larger than the size of the debt.

In the face of disruption of existing social and economic norms and environmental challenges, there is much good news coming from the movement of hundreds of millions of people out of poverty. Australia’s comparative advantage in many areas such as higher education, medical research, environmental management etc means it is well placed to take advantage of the new economic age. Trade agreements recently signed by Australia are important policies to cement Australia’s future prosperity. Australia can’t continue to attempt to keep the economic structures of the previous century when resources (both human and physical) need to be channeled into new industries. Over-burdening new industries through ever rising and uncertain tax burdens to support declining industries is a recipe for European style outcomes. Australia had 15 years of extra income growth to deal with the structural transformation and governments failed to use this windfall. There is a not a crisis in Australia yet but now is the time that reform needs to ramp up. Now is the time for long term thinking to defeat short term politics.

For reform to be successful, it needs to be bipartisan. While the Left in Australia resists acknowledging or apparently understanding that there is a serious problem, minor parties, whose existence rests on maintaining the status quo, will block reform. The Right wing of politics needs to understand that it is important to have a robust safety net particularly when significant structural reform is undertaken. To begin where the current government began its reform agenda suggests a good deal of confusion about the real challenges facing Australia. The focus has to be on implementing sustainable economic, social and environmental policies.  While reform stalls, the costs of inaction will continue to rise. This is the biggest intergenerational issue Australia faces.

      

 

 

Inflation targeting was seen as a core guiding principle for central bankers because it gave central banks a clear goal for policy – a goal which the central bank could control in the medium term and which could be measured and forecast in the time frame relevant for monetary policy. Achieving the inflation target was important for maintaining the credibility of monetary policy and anchoring expectations about policy. This was an important driver of growth during the last two decades. Having an independent central bank with a clear mandate and quantifiable target diminished the problem of using monetary policy for political purposes that so many governments had done over many decades. In Australia, inflation targeting was important in tying the hands of government and during the recent commodity boom since 2000 contributed to a much better outcome than in previous boom bust cycles. The relative mis-handling of fiscal policy over the same period demonstrates that the outcome for the Australian economy would have been much worse if politicians also had control of monetary policy in additional to fiscal policy.

The key benefit of inflation targeting as a concept, was not inflation per se, but having a measurable target that the central bank could aim for and could influence. One of the strengths of inflation targeting is in the face of a demand shock. With demand rising faster than supply such as occurred in Australia from 2002, raising interest rates to dampen inflation would also reduce the extent of excess demand in the economy. This response of monetary policy would work to both reduce output volatility as well as inflation volatility over the cycle. In advanced economies, during the past two decades when demand shocks have been important, inflation targeting worked well. However there has always been a well-known problem with inflation targeting which is highlighted in the academic literature. This is in the face of supply shocks this policy does not work well and can accentuate output volatility. Take the example of a fall in productivity growth (a negative supply shock). Falling productivity would cause both a rise in input costs and a fall in output. An inflation targeting central bank would tighten monetary policy as input costs rose but in doing so would reduce real GDP in the economy. Thus monetary policy would lead to a worse outcome for the real economy than caused by the shock alone. In joint work with Dale Henderson in the early 1990s we showed that an inflation targeting central bank also accentuates output losses as risk increases in an economy.

This is important in several dimensions. It has always been a problem for emerging economies which face more extreme supply shocks (e.g. weather events, political instability etc) than demand shocks (excessively exuberant consumers). The mantra that central banks in emerging countries should follow inflation targeting has caused problems for the real economy in many cases. The benefits of credibility in policy was offset by real output losses from overly tight policy. But it is even more relevant today for advanced economies because of the current problems in these economies of falling productivity and rising risk. Inflation targeting is not the best framework for central banks in these circumstances.

This problem can be addressed if the focus of the target is shifted from inflation targeting to nominal GDP targeting. Nominal GDP growth is the sum of inflation and real GDP growth. To understand why nominal GDP targets works well, consider the case of a fall in productivity (equivalent to a rise in input costs). An inflation targeting central bank would tighten policy in response to rising inflation. A central bank following a nominal GDP target would combine the rise in inflation with the fall in real GDP and not tighten policy or may even loosen policy if the expected fall in real GDP is larger than the expected rise in inflation. The outcome for the real economy would be better but expectations from having a clear policy rule would not be undermined.

The second issue where policy will need to adjust is because of the prevalence of countries in the global economy with high ratios of nominal debt to nominal GDP. While fiscal policies will ultimately need to tighten to bring down the level of debt in many countries, it is also important that the rate of nominal GDP growth is maintained. Falling debt levels combined with falling nominal GDP growth means that the ratio of nominal debt to GDP may rise, even as countries attempt to get their fiscal deficits under control. This is a recipe for bad economic outcomes, as southern European governments are discovering.

On the face of current realities, it is clear that central banks in many countries need to shift their focus away from inflation targeting or exchange rate targeting to nominal GDP targeting. The sooner this happens the better for the world economy. The management of monetary policy in the next five years will likely be very different to current conventional wisdom.