What I've been up to during the election

Sorry I've been behind on sending out newsletters recently. But I have been busy! Many of our readers are interested in the national economic debate, so I thought they might like to check out a couple of articles that I have written in the context of the debate - reproduced below, and accessible here and here and discussed here.

From The Australian, Wed 22nd Sept 2005

Economics and the election

Over the last decade Australia has developed a reputation as a 'miracle economy'. While Asia experienced a financial crisis, Japan remained mired in recession and then SARS hit Asia again, and while America slowed in the wake of the tech wreck and September 11, we powered steadily on - growing at a little under 4% per annum despite a savage drought.

We had a bit of luck. But mostly our performance was the reward for Australians' hard work and their preparedness to vote for good economic policy. Over twenty years we slashed tariffs, introduced competition policy and freed up financial markets. We rebuilt our tax system, restored fiscal responsibility to government, strengthened the independence of monetary policy and made our labour market less bureaucratic. Utilities and regulation were rationalised. All this required political courage and, contrary to the conventional wisdom that politicians are congenitally 'poll driven', governments of both political persuasions took huge political risks to achieve what they did.

The result was a surge in productivity and a new competitiveness. After a long slow decline, our export market share grew strongly. Our economy's new strength and resilience, and generally deft judgements by our central bank meant that when the international environment turned sour we kept growing strongly. In these circumstances import volumes continued to soar and exports faltered. But this was a temporary luxury our new found competitiveness meant we could afford.

But it's six years since the Asian downturn and three years since September 11. In some ways our luck has turned. There's been a record grain harvest and a Japanese recovery. And China's growth has transformed our terms of trade to their highest in 30 years as it buys our mineral exports and depresses the price of the manufactures we import.

Yet our gains are beginning to be challenged. Imports are surging, but export volumes have stagnated through this period rising a little only very recently. In fact a major driver of our poor export performance is no longer the drought, or weak external demand, but the loss of market share. Before the Asian crisis our share of world exports was just short of 1.2% and rising. It fell sharply with the Asian Crisis and the drought, as one would expect. But, following a brief recovery it is now below 1% for the first time in the series' history.

We are now running current account deficits a fraction under 6% of GDP -running up our foreign indebtedness by almost $50 billion each year. Had our terms of trade not risen the figure would have been around 8% of GDP. It is hard to believe that investors funding our deficits would have been unconcerned by such figures. And future rises in export volumes should be discounted to some (relatively unpredictable) extent by the likelihood that export prices will fall back and that we will have to pay more on our borrowing as global interest rates rise.

None of this is to counsel despair. But it does suggest due prudence. It shows the need to renew our commitment to economic reform and so the need for a broader economic debate in this election. We need to focus on building the next economic miracle not spending the proceeds of the last one.

Economic debate in this election should focus on the parties' plans to improve:

• Prudence: We should run substantial surpluses on recurrent budget during good times. This 'loads the fiscal cannon' giving us room for equally big deficits to fight future downturns. Budget surpluses also help redirect resources towards investment and exports to remake the next economic miracle and pay our way in the world. But large surpluses are politically hard to sell - few governments want their hard work handed over to their political opponents as a financial windfall. So we should continue to develop our fiscal institutions. Both parties have now adopted policies for 'funds' for the future which will help. Policies to set up such funds should be made more concrete in due course. And, as the BCA proposed some time ago, there is a case for developing more independence in our fiscal institutions. We should also turn around our very poor private savings performance by expanding and simplifying our superannuation system and continuing the gradual extension of compulsory super.

• Productivity: Governments play an important role in funding critical infrastructure in our economy whether it is physical as in the case of roads, or in 'human capital' and innovation that makes us more productive. In each of these areas we could do better. Especially with surpluses on recurrent budget we should be far less afraid of borrowing to fund economically justified investment. If we are to have an election auction, as much of the bidding as possible should focus on investment in future human capital, including improved incentives for business research, development and commercialisation.

• Participation: When in government, both major parties have taken hard decisions on tax reform. Yet there is plenty still to be done. Most particularly we need to lower high effective marginal rates of taxation further up the income scale and most urgently for families on much lower incomes whose family payments are withdrawn as their household income rises. Ultimately we need to rebalance our country's tax mix, fix the work/family balance and get work/retirement choices right. Policies ranging from taxpayer-funded maternity leave to life-long learning provision for older workers then come to the fore.

There would be something sad and ironic about a country that had, not without pain, woken up from the complacency bred during its time as the 'lucky country', again beginning to backslide. The alternative is so much more appealing: Australia - the country that learned to make its own luck - and kept on making it.

Nicholas Gruen, CEO, Lateral Economics and Peach Financial

Vince Fitzgerald, Chairman, Allen Consulting

Peter Jonson, Chair Emeritus, Melbourne Institute

Professor Allan Fels, Australian and New Zealand School of Government

Professor John Freebairn, Melbourne University

Professor Glenn Withers, Public Policy Program, ANU.

Published by Australian Financial Review on 13th September 2005 as "Time for a new economic prudence".

Funding the Future from Surpluses AND debt.

Part of the political price we've paid for economic reform has been the "dumbing down" of its basic logic. The undoubted need for responsible budgeting sees us in thrall to the now well entrenched bipartisan cult of reducing debt at all costs. The Liberals' Future Fund and the ALP's Intergenerational Fund take us one step further, moving from a commitment to budget balance over the cycle towards sustained budget surpluses - in the Liberal's case using budget surpluses to fully fund the Commonwealth superannuation liabilities by 2020. By my rough reckoning, that's a new commitment to a budget surplus of around $4 billion each year for fifteen years - quite a turnaround.

Yet, however simplistic the economics driving the Future Fund, no-one can doubt the timeliness of aggressively building surpluses during the good times - so we can aggressively fight the next economic slowdown. The trouble is that ever since Jeff Kennett left office leaving a huge budget surplus for the enjoyment of his political opponents, it's become politically savvy to sail much closer to the fiscal wind - to keep budgets in surplus, but only just.

If we need the inspiration of fully funding superannuation to motivate us to run large surpluses during a boom, well and good. Lets hope the position of strength that it builds for us will give us the confidence to expand fiscal policy aggressively in the next downturn. We have to make sure that the Future Fund is built to help facilitate this.

And I'm hoping this new focus on financial strength will be the beginning of a new prudence in government - which will place us in a sufficiently strong financial position for our politicians to finally be able to admit something that any economics student or company director can tell you. Prudent borrowing to invest has been a foundation of public and private wealth building since Adam was a lad.

And as for fully funding super, just between you and me, we can do it now! Over just a few years we should borrow the unfunded liability and invest it in a diversified portfolio of high growth investments here and overseas. Over any appreciable time it will earn around $2 billion more than the interest cost of the debt each year though of course, like dividends from the RBA or Australia Post, these returns could not be relied upon in any given year.

What's the catch? None really. Over a long period a debt-funded portfolio of real assets wouldn't just increase return. It would lower risk by correlating returns more closely with government's future liabilities and diversifying the Government's portfolio of assets. We should also move towards a more rational approach to debt more generally - enabling us to borrow to invest in assets such as economic infrastructure for instance.

However - learning from the mistakes of the past - we should continue to strengthen the institutions of budget transparency, prudence and flexibility. We should require independent and public cost benefit analysis for infrastructure investments. Fiscal transparency functions should be signed off by independent integrity agencies, like the Auditor General. Indeed such bodies should have a responsibility to publicly advise governments on managing fiscal policy the way the Productivity Commission advises government on microeconomic policy. This much could be promised in this election from government or from opposition. It was after all the Bracks Opposition that first promised the Auditor General's oversight of the Victorian budget.

Beyond this, governments should move towards giving such agencies a role in managing the fiscal balance in the same way we have independent oversight of monetary policy by the Reserve Bank - subject to overrule by the government of the day. This was suggested by the BCA a few years ago and continues to generate interest and support from American opinion leaders like former Deputy of the Fed, Alan Blinder and influential commentators in Europe and England. It is one of just four priorities for continuing economic reform set out by young Australian public policy graduates of Harvard in their recent book Imagining Australia.

Goodness knows when politicians will once again acknowledge the obvious - that however important it is, what we owe pales into insignificance compared to what we're worth. If one lacks the child's naivete, it takes a little courage to expose the emperor's minimalist fashion sense. But not a lot. It is harder to do this from Opposition, but when in Government the usual formula applies - you can change the game when you're right, you're acting from a position of strength and you can tell your story. In other words when you're showing leadership. And though it has its risks, so too does risk aversion. Remember how John Howard was thought of before he chanced his arm on tax reform? Though there's no risk free formula for political longevity, leadership is usually rewarded in the long run. It helps create political and economic momentum. People respect you for standing for something, and they might even come to value what you've achieved.

Borrowing to invest should not be scary, but thinking it has made it so. Somehow we've confused it with profligacy. After the thesis (debt and profligacy), came the antithesis (prudence without debt). Now for the synthesis (prudence with debt). We can't say with any certainty when the change towards more government borrowing will come, but come it will. How much better if it comes as a reinvigoration of our (now fading) preeminence in economic reform rather than as result of fatigue and indifference, and a slide back towards the mediocrity we once knew so well?

Dr Nicholas Gruen is CEO of Lateral Economics and Peach Discount Mortgage Broking. He is working on a book entitled Reimagining Economic Reform. ngruen@lateraleconomics.com

Naturally I'd be interested to get any of our subscribers' responses to these ideas and their comments more generally on which party and which policies they think would be in our long term economic interest.

9^th September 2005

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The observations made here are general and indicative. They are not warranted as free from error in any respect whatsoever. We are not financial or tax advisers and you should not rely on any aspect of these comments without taking independent financial advice relating to your own specific circumstances. We suggest you obtain advice on a fee for service basis rather than from someone who earns commissions from investments they recommend.