For Victoria, it's a case of life in the slow lane

THE problem with the Australian economy is that there isn't one. Rather, there are two of them, or arguably several. The data groups them as one, which makes it a misleading guide.

You know the story, but even so, the data is astonishing. Half of Australia's growth is coming from investment in one sector, mining, which generates just 7.5 per cent of our output. In the past year, on the latest figures, mining investment grew by 80 per cent. This is the biggest mining boom we've seen.

The other half of Australia's growth comes from the rest of the economy. Growth in the mainstream of our economy is just 1 to 2 per cent, in line with population growth. To put it another way: take out mining and its offshoots and growth per head in the rest of the economy is about zero.

Take out mining from the capital expenditure figures, and they show business investment in the rest of the economy has slumped to its lowest level in almost 40 years: less than 5 per cent of GDP. At last report, non-mining business was forecasting a further fall in 2012-13.

If they were some minor part of the economy, you might say, so what? But this is not minor: it's the mainstream of the economy, it's High Street, it's Victoria, New South Wales, south-eastern Australia, south-eastern Queensland. It's us.

Victoria is at the centre of it. After 20 years of surprisingly solid, even enviable, growth, this state is now at the crossroads. The forces that drove its growth in recent years have gone into reverse. The headwinds it has struggled against have grown stronger and more dominant. It is not clear where the state's next drivers of growth will come from.

The story is certainly not all bleak. Victoria's housing industry is no longer running at record levels, but it's still the shining light in a weak national outlook. A couple of big hospital projects saw the state also lead Australia in 2011-12 in new non-residential building approvals. The Baillieu government has budgeted for record infrastructure spending in 2012-13 and is looking for ways to accelerate that in future. And the state continues to outperform the rest in attracting new visitors.

All through Victoria, creative minds are finding ways to overcome the problems heaping up on them: the overvalued dollar, the new wave of consumer restraint and cost-cutting by other businesses and governments. Despite the dollar, many are building or maintaining export-oriented firms. Victoria's exports of goods in 2011-12 grew 10 per cent, faster than Western Australia or the nation.

To explore the options for Victoria's enterprises, The Age has joined with Victoria University and the Committee for Melbourne to present a conference later this week, Victoria at the Crossroads, with speakers including Prime Minister Julia Gillard and Victorian Treasurer Kim Wells, and experts from a wide range of areas.

The springboard was concern that global and Australian economic conditions are now working against Victoria. The state will have to find new sources of growth or remain stuck in the slow lane of a two-speed economy.

For example:

. In the year to March, demand (total spending) grew 10 per cent in the mining states (WA, Queensland and the Northern Territory) but just 2 per cent in the rest of Australia, including Victoria.

. The state's unemployment rate has risen in a year from 4.9 per cent to 5.5 per cent, with the official figures showing 27,000 full-time jobs lost and 41,000 part-time ones added.

Ominously, the June survey of the Victorian Employers' Chamber of Commerce and Industry found only 9 per cent of its member companies surveyed expect the Victorian economy to strengthen over the year ahead, while 61 per cent expect it to weaken.

The problem is that Victoria has lost its main drivers of growth. Spending by foreign students in the state fell by $1 billion in 2010-11 as the high dollar, tougher migration policies and anti-Indian violence sent students elsewhere. The heavy debts we took on in giddier times now restrain consumer spending. In Spring Street and Canberra, expansionary budgets have given way to contractionary ones.

Housing starts in the six months to March were down 16 per cent from their record high a year earlier, and housing is a big buyer of goods and services. House prices have fallen for a year and a half, provoking caution.

Manufacturers from Ford to the backyard sheds are doing it tough and shedding jobs under the crushing weight of the high dollar. And investment surveys suggest there is worse to come.

This is not just Victoria's story; it's the story of south-eastern Australia. The Reserve Bank's recent interest rate cuts will help at the margin, but the core message from policymakers is: it's your problem.

That means it's got to be our solution. We must be tough, resourceful, patient and creative: to find better ways to work, make new products and find new customers. Good luck.

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It is time we intervened to hold back the dollar

OUR problem is the dollar. You can pontificate until you're blue in the face about productivity, or business taxes, or the carbon tax or cautious consumers and they're all important. But what is putting otherwise viable Australian businesses at risk now is the fact that our dollar is too high for them to compete.

On the broadest measure, the Australian dollar is now 72 per cent higher than it was a decade ago. Against the US dollar, it has almost doubled. At $US1.05 or more, it is 50 per cent higher than its long-term average of US70?, between 1985 and 2005, before the mining boom drove it up.

A high dollar makes Australian exports more expensive in the rest of the world. It makes imports cheaper here. It makes it cheaper for us to spend our money abroad as tourists or consumers and more expensive for the world to spend its money here.

If you lower the dollar, the other problems become second order issues. If you can't lower it, and it keeps going higher, then business and government may have to move hard and fast to find ways to save enterprises and the workers they employ.

That is the reality the Reserve Bank highlighted in its quarterly statement on monetary policy last week. It is the reality that has made its former board members Warwick McKibbin and Adrian Pagan urge it to try new ways to stop foreign demand for Australian dollars driving up its price.

In March, I wrote on this page that we need to talk about the high dollar, suggesting the Reserve should drop its hands-off policy, and intervene to cap its value, as the Bank of Switzerland has capped the value of the Swiss franc. That conversation has now begun, and about time.

The stakes are high: not only for our trade-exposed enterprises and their workers, but for both sides of politics. On July 1, we began living with the carbon tax that Tony Abbott has told us over and over will be "like a wrecking ball through our economy". It has become the defining issue of our politics, the prime mover for Abbott's rise in the polls and Julia Gillard's fall. Now the rhetoric of both will be put to the test.

In July, the wrecking ball failed to wreck anything. Last week the Bureau of Statistics estimated that seasonally adjusted employment grew by 14,000, and private analysts TD Securities and the Melbourne Institute estimated that inflation rose by just 0.2 per cent.

Of course, these are early days, and survey data can be wrong. But it was a preview of the potential damage to Abbott's credibility if the carbon does not wreck the economy. The polls show he himself is unpopular; if his campaign against the carbon tax turns out to be hollow, the political balance could swing sharply against him.

But the argument cuts both ways. If the economy goes badly in 2012-13 and I mean the economy of south-eastern Australia, where Labor has 60 of its 72 seats in the House of Representatives then Labor and its carbon tax will be blamed, regardless of whether or not it really caused the slump.

The Age economic survey last month found an overwhelming consensus among private forecasters that Australia would do well in 2012-13. Virtually none think the carbon tax to be a wrecking ball through the economy.

But the economic tides now are very uncertain. Even the Reserve Bank, with its well-documented tendency to be over-optimistic, now concedes the big risk is that the economy in 2012-13 will go worse than expected, not better.

Part of the reason for that, as the Reserve sees it, is Europe's inability to solve its problems. It is sanguine about China, although the anecdotes from there point to a more alarming slump than the statistics admit to. But it is also worried that the rising dollar is doing more damage than its models have forecast and in Australia too, the anecdotes point to deeper problems than the statistics so far show.

Most observers expect the Reserve to do nothing more than voice concern. It has never intervened in the markets to keep the dollar down, only to push it up. Deputy governor Philip Lowe said last month it was hard to make a case that the dollar was overvalued. But then, the International Monetary Fund disagrees, estimating that in June, when the $A was roughly at parity with the $US, it was already overvalued by 5 to 15 per cent.

What could we do? Two options stand out:

The Swiss solution: impose a cap on the Australian/US exchange rate, maybe at parity, and print dollars to sell whenever the cap is threatened. There is no limit on the Reserve's ability to create Australian dollars only the risk that they will end up back here adding to inflation, and the risk that it will become a huge holder of US dollars and other currencies.

The McKibbin solution: since the main surge in demand for Australian dollars is from other central banks buying them as safe investments, the Reserve should sell them directly to its cousins, printing dollars to meet their needs, and so taking pressure off the dollar in the markets.

I'll say it again: we need to talk about this. We should not let fear of trying something new cost us good enterprises and good jobs.

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Inequality fell under Swan, but it wasn't his doing

WAYNE Swan tells us his source of inspiration is Bruce Springsteen, and his anthems for the working-class battlers of America. It's a new way to try to persuade us that Labor's goal is to make Australia a more equal place and the Liberals' goal to make it a more unequal one.

It might work, because this is an issue on which Labor has a good story to tell. While John Howard in his first eight years as PM was sensitive to the needs of the "battlers", he lost office largely because he lost that focus as he went on. Swan as Treasurer has done nothing dramatic to make Australians more equal. But he has persistently pushed his "Labor values" into virtually every reform, every fiscal package, to nudge the outcomes in that direction.

It's gone surprisingly unnoticed, except by those on high incomes, who have found themselves excluded from virtually every initiative Labor has taken to "ease the burden on struggling Australian families". That has fuelled the perception among some of them that Swan is a class warrior, and his bid to recruit Springsteen to the cause only intensifies that.

To take a few examples:

. All of Labor's handouts to families were targeted to lower and middle-class households, and left out those on incomes above $150,000. High-income earners have lost their tax rebates for private health insurance, and those on more than $300,000 have had their superannuation tax breaks pruned.

. Making employers lift their superannuation contributions from 9 per cent to 12 per cent could make workers better off, unless employers recoup the cost from lower wage rises.

. Pensioners, including the disabled, won big pension rises in 2009 from the Harmer review although, typically, the unemployed were excluded.

. The big bipartisan tax cuts from the 2007 election went everywhere, but Labor's tax cuts since have gone to the lower half of income earners. The latest lot cut tax by $10 a week for workers on $25,000 a year, but just 5? a week for those earning $80,000 or more.

No economist has tried to piece it all together, so we don't know how much of a difference it has made. The latest income distribution data from the Bureau of Statistics is for 2009-10, and won't be updated for another year. And in any case, so many other factors affect income distribution that its data can't tell us what impact government policies have had.

For example, the distribution of wages and salaries has become far more unequal as we have moved away from national wage fixing and industry awards to enterprise bargaining and individual contracts. That was what was meant to happen, but the size of the shift is startling.

Bureau of Statistics figures show that in the three years to August 2011, average wages for full-time workers at the bottom fell by $4 a week, or 0.6 per cent. Those in the middle had an average wage rise of $36 a week or 3.4 per cent, while those at the top had an average rise of $206 a week, or 10.3 per cent. These changes swamp anything the government has done.

The wage share of national income has fallen and the profit share has risen, so that returns to investors now account for a far bigger share of income. This boosted the share of income going to high-income earners in the boom years, and has shrunk it since the GFC bust.

Moreover, Swan's concern for working families specifically excludes the unemployed. Even in opposition, when he wrote a book, Postcodes, on the inequity of Australia's income distribution, he ignored the ugly fact that we pay the unemployed a benefit below the poverty line. Now in office, this Springsteen fan ignores them still, expecting them to live on $35 a day.

But Labor has kept intervening in small ways to favour working battlers, and it is false to pretend otherwise as The Australian did last Thursday when it ran across its front page a supposed expose.

"Inequality has grown on working-class warrior's watch", its headline ran. "Income inequality has increased slightly on Wayne Swan's watch", its story began. Yet the figures it cited showed the opposite.

It reported that inequality had increased over a 10-year period (which 10 years was not clear). Yes, the bureau data shows inequality did rise between 1995-96 and 2007-08, but that was under the Howard government. Swan became Treasurer only at the end of 2007. His first budget took effect in 2008-09. The Australian chose to blame Swan for the growth of inequality under Howard.

Its story eventually quoted the data for what happened under Swan's watch. The share of income going to the top 20 per cent of earners "rose to 47.6 per cent in 2007-08 before easing back to 46.7 per cent in 2009-10". Inequality in fact fell on Swan's watch.

But that wasn't primarily due to him. The GFC cost investors a heap of money, and investors tend to be in the top 20 per cent of income earners. Let's get real.

What is remarkable in all this is that, in small ways, Swan has quietly put income equality back on Australia's political agenda. It's nothing dramatic. Probably all Labor has done has been to moderate the growing inequality of wage and investment income.

But if you believe in equality of opportunity, it is a step forward. Those doing well in the markets don't need more help from government. It should focus on helping those who need it.

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We agree on most things, right?

THE winner in Saturday's byelection was the party that didn't stand. The Liberals stood back to watch as Labor and the Greens fractured the alliance that is the alternative to them, with neither winning a real victory.

Labor held the seat, and with it came the end of the era when the Greens could expect preferences to favour them. Yet at the end of counting on Saturday night, Labor's vote was down 2.3 per cent on first preferences, and 4.8 per cent on the two-party-preferred vote. Melbourne was a safe Labor seat for 100 years, yet on Saturday Labor won just a third of the vote.

The Greens' vote rose by 4 to 5 per cent on both measures, but they lost again in an election they had expected to win. The results confirmed that preferences are now working against them. Without preferences, the Greens will not win lower house seats in future. Without seats, they will lose momentum. Without momentum, they will revert to the fringes.

It was a weird result. As of Saturday night, only 66 per cent of the voters had cast a vote, and 8.5 per cent of those were informal. In 2010, 84 per cent of Melbourne's electors cast a formal vote; this time, it will be around 64 per cent. One can assume that most of the absent 20 per cent would have voted Liberal: so had the Liberals stood, Labor's vote would have been lower still.

The Liberals must have been left chuckling when NSW Right powerbroker Sam Dastyari attacked the Greens his government's partners as loopy extremists akin to One Nation. The only thing voters can conclude from that is that the Labor-Greens alliance is a mismatch of enemies, an unstable partnership bound to fail.

All three parties need to step back and take a look at how they relate to each other. The Liberals dominate the federal scene, but their lead is brittle when the polls show half their own supporters want Malcolm Turnbull to replace Tony Abbott as leader. And while Ted Baillieu may have no plausible rival, his own polls are worrying for a first-term government that should be on its honeymoon.

Baillieu has enemies to the left and right, but fewer friends than he deserves when his government is mostly making sensible decisions. A prime example is its decision to reopen New Street, one of Brighton's main roads, by installing relatively cheap boom gates. It rejected the two bad options: to leave a main road closed, as Labor did, or to put in an expensive underpass, as some locals wanted. You just wish it would apply the same common sense by revisiting its excessive TAFE cuts and scrapping its wasteful policy to put two security guards on every railway station.

But, of course, Labor and the Greens can't praise any decision by the Baillieu government, because we seem to have a new rule that oppositions must oppose virtually everything a government does. The only Gillard government policy that Abbott supports is to send soldiers to fight in Afghanistan.

My thesis is that Australia, and Victoria, cannot afford the degree of political partisanship we now have. The centre needs to be strengthened. In reality, most of us agree on most things. We need political structures that reflect that.

There will always be partisanship: politics is a contact sport. But we need to create a second avenue, in which big long-term issues are dealt with on a bipartisan (or all-party) basis, so that business has certainty about future policy frameworks and can plan investments accordingly.

Last week I wrote on the impasse on infrastructure investment. We want better roads and public transport, but, egged on by whoever is in opposition, we oppose every means of paying for them: higher taxes, higher debt or user charges such as road tolls.

Past governments dealt with this by handing such issues to all-party committees to resolve on the understanding that they suspend hostilities on the issue and work for a joint decision, rather than split on party lines. It offers oppositions a partial share of power, so that decisions with big consequences are made by weighing up long-term costs and benefits, not short-term political ones.

Climate change is another issue on which a bipartisan approach is needed. Whatever system we adopt to tackle it, it will work only if business can trust future governments to honour commitments made by the current one.

The Liberal Party supported a carbon price under John Howard, Brendan Nelson and Turnbull as leaders. Climate change requires a long-term bipartisan policy so business can invest with confidence that the goalposts will not be moved. Kevin Rudd wasted his opportunity by trying to use the issue to divide the Liberals, ultimately causing his own downfall.

Australia deserves better. We won't get it from Abbott, who is partisan to the core. We won't get it from Gillard or Rudd either. But we could get it from Baillieu and Daniel Andrews. They could show the next generation of Australian political leaders the benefits of taking some big, politically difficult issues out of partisan politics to get the decision right.

Where would the Greens fit into this? In Tasmania and the ACT, they are working well in coalition or partnership with Labor governments, and accept compromise as normal. In Victoria, they seem to stand alone. Should they be islands of purity, or build bridges to become part of the main game?

Their model should be Germany where the Green "realos" (realists) wrested control from the "fundis" (fundamentalists) to became part of the Schroeder government which transformed the country and form state governments with both sides. Compromise is not a dirty word.

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Getting the roads we need. Let's talk about it.

WHAT would you think if the state decided to sell the Eastern Freeway, West Gate Bridge, or the Western Ring Road to become privately owned toll roads - and invest the revenue from the sales to build better road and rail links?

How would you react if, in future, there were no new freeways, only toll roads, so that the cost of building them falls entirely on users, rather than on taxpayers?

Would you agree if the state decided to give up its AAA credit rating and pay higher interest rates so that it could borrow more money and build the really big projects, such as giving Melbourne an east-west link or a metro rail network like that of Paris or London?

And would you object if the government built a smaller toll road to the port for trucks and commercial vehicles only, with the rest of us banned so that we don't clog it up?

If you haven't thought about all this, better start now. These radical ideas are proposed by federal Treasury, Infrastructure Australia and the private sector to solve the problem of how to finance the $700 billion of infrastructure Australia will need over the next generation.

These ideas are not Baillieu government policy; far from it. Treasurer Kim Wells says the state is considering all options (toll roads) for funding future freeways, but has no plans to sell existing freeways.

Still, that doesn't rule it out. And while the Kennett government took a bit of flak when CityLink turned existing freeways into toll roads, that didn't cost it any seats.

The Gillard government too hasn't endorsed these ideas. Infrastructure Australia chairman Sir Rod Eddington wants governments to start a community debate, but Treasurer Wayne Swan and Infrastructure Minister Anthony Albanese have been too shy to say a word about them.

Some think governments would rather sell off assets remote from our daily lives: ports, for example, although that has its own problems. And you can understand why any politician would be reluctant to suggest that we pay to drive on roads that we now use free of charge.

Similarly, it would take a brave politician to argue that Victoria should double its debt to build the infrastructure we need, rather than accept congestion and poor services as the price of a AAA credit rating.

But Infrastructure Australia, and their advisers on the infrastructure finance working group, are right: this is a debate we have to have. These are issues that touch on our daily lives: the taxes and charges we pay, and the efficiency and convenience of the cities we live in.

Yet our knee-jerk reaction is to oppose all this. Yes, we want better infrastructure, but we're against having to pay for it through higher taxes. We're against governments taking on higher debt to pay for it. And we're against having to pay for it through user charges such as tolls.

The debate needs to move beyond these prejudices. If we don't, our politicians will remain trapped within them, and we will not get the new infrastructure we need. Anyone who wants Melbourne to have better roads, or a metro rail system, needs to start thinking about how they should be paid for.

A good place to start is the refreshingly frank report of the infrastructure finance working group, Infrastructure Finance and Funding Reform, at www.infrastructure.gov.au. Chaired by Jim Murphy, deputy secretary of federal Treasury, the group brought together infrastructure and finance experts from the federal government and the private sector - but no one from the states, which allowed it to be very candid about the options.

It argues that the states have no more room to borrow without losing their AAA credit ratings. In Victoria, John Brumby and Ted Baillieu have pushed state debt almost to the limit for AAA-rated borrowers. Even to keep up existing infrastructure spending after 2012-13, Baillieu would have to tax more, or cut spending on other priorities, or bust the AAA limit and accept a downgrade and higher interest rates.

Clearly, none of those are politically palatable options, but the working group urges governments to think hard about the last one. If the benefits of having the infrastructure outweigh the benefits of having a AAA rating, then it makes sense to borrow and build. The group notes that federal government transport economists estimate that its current infrastructure projects will deliver a return of $2.65 on every $1 invested.

In the past, roads such as CityLink were built as private toll roads, but will ultimately revert to state ownership. The report suggests this be reversed. After new toll roads in Sydney and Brisbane fell far short of targets, superannuation funds see the privatisation of existing roads as much safer investments. The report argues that the states should sell them, use the money to build new toll roads, preferably as joint ventures, then once they're running smoothly, sell them and build more.

The report makes one ugly call. Believing the states will be reluctant to embrace toll roads and asset sales, it wants the federal government to coerce them into doing so, by funding new road projects only if they are built as toll roads. To me, giving Canberra more power is not progress.

Another concern is that its blueprint envisages a road network with multiple private sector owners, yet operating as one flowing entity. This suggests serious challenges that the report does not explore.

But the working group and Infrastructure Australia have put this on the table, as one of the big issues Australia must face up to. If the politicians are reluctant to do so, it's our job as a community to take it up, to think past the stereotypes and simplicities, and face those hard decisions. If it were our choice, what would we do?

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Productivity: we're winning half the battle

"Productivity isn't everything, but in the long run, it's almost everything. A country's ability to improve its standard of living over time depends almost entirely on its ability to raise its output per worker."

US economist and columnist Paul Krugman (1994).

WE HEAR a lot about productivity now, and with good reason. Productivity is what makes Australia a rich nation and India a poor one. But since 2003-04, the statistics say that Australia's productivity has been falling.

Why do office workers and carpenters, teachers and taxi drivers, earn so much more in Australia than they do in India? Because the productivity of the Australian economy is so much higher than that of India.

What is productivity? In a word, efficiency. A recent Reserve Bank paper defines it as "the efficiency with which an economy employs resources to produce economic output". Or, as economist Saul Eslake puts it: "Productivity is what a workplace, a business . . . or a nation gets by way of goods and services for what it puts in, in terms of labour, capital and other factors of production."

When 75 per cent of us are employed in services, how are we more productive than services workers in India? Well, start with the computers at our desks. They have relatively fast broadband and good software that allows us to do jobs quickly (so long as we don't start surfing the net). We are skilled in using them and thinking laterally when we run into problems.

Second, our workplaces are run so that we work at full stretch, whereas Indian shops usually have more workers than customers.

Technology levels, skill levels and work intensity: these are the factors that University of Queensland economist John Quiggin singles out as the keys to productivity growth. They're not the only ones: Eslake highlights the role of economic reforms in lifting productivity growth. The switch to workplace bargaining in the 1990s is widely seen as having opened the way for productivity-enhancing trade-offs.

The quality of infrastructure matters, too. One argument for the NBN is that high-speed internet connections will raise productivity by allowing us to do more tasks more quickly. Ridding Melbourne of the congestion caused by level crossings would raise productivity by cutting delivery and transport times.

Policymakers are focused on productivity because, after a decade of rapid growth in the 1990s, the statistics say productivity in Australia peaked in 2003-04 and since then it has gone gently into reverse.

Labour productivity the amount we produce per hour worked has kept rising, but at a far slower pace. And capital productivity the amount we produce per dollar invested has gone from shrinking slowly to shrinking fast.

Should we be worried? And if not, why not?

Many analysts have shed light on Australia's productivity puzzle. There are differences of emphasis between the conclusions of policy insiders (the Productivity Commission, Treasury and the Reserve Bank) and those of independent economists such as Eslake and Quiggin. But there is a broad consensus that, to coin a phrase, the glass is half-full (or half-empty). Part of the productivity slowdown is a mirage, but part of it is real.

The mirage stems from what Productivity Commission consultant Dean Parham calls "the usual suspects": events (or errors) that lower official measures of productivity, but don't change underlying productivity. They include the timing of investments, temporary issues such as drought, shifts between industries, and measurement errors, such as ignoring the improved quality of the goods and services we produce.

The first is the big one. In a decade, the mining construction boom has trebled the industry's workforce and doubled its capital stock. Yet so far it has created only a 30 per cent growth in output so productivity in mining has slumped by 40 per cent.

But most of that is just a timing issue. The projects employing those workers and capital are creating long-term assets that will deliver huge increases in future mining output and productivity.

Productivity in the electricity industry has slumped for similar reasons. There's a huge wave of investment under way in transmission and distribution lines, with no increase in output. Electricity, water and mining account for roughly half of the productivity slump.

But what of the other half? There are many opinions, but few unarguable facts.

Eslake blames the lack of big economic reforms since the GST came in. Reserve Bank board member John Edwards takes a more benign view, pointing out that the '00s, like the '80s, saw a lot of growth in employment, largely in low-productivity industries. "Higher participation," he argues, "is not something we should complain about."

I lean towards Edwards' view, but there is truth in both explanations. And for business pressured by the higher dollar, raising productivity is not an option, it's a necessity.

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Emissions trading. The economists are right

I'VE come to think we should take more notice of economists. You might see them as impractical nerds. But look back over our long debate on how to tackle climate change, and one thing stands out: the economists got it right, the politicians got it wrong.

Last year the Economic Society of Australia surveyed its members on 46 policy issues. On some, it found economists evenly divided: on the merits of the NBN, for example, or whether Australia should promote nuclear power, whether patients should pay more of their health bills, and whether the GST should be lifted so income tax and company tax can be reduced.

But on other issues economic opinion is clear cut. Top of the list is whether taxpayers' money should be spent on big infrastructure projects without an independent publicly released cost-benefit analysis first to check the project stacks up. The survey found 85 per cent of economists want cost-benefit studies to be mandatory. (Who doesn't? Politicians.)

Surprisingly, the second most clear-cut response was on climate change: 79 per cent of economists agreed that price-based mechanisms a carbon tax, subsidies or an emissions trading scheme are a better way to tackle climate change than using direct regulation.

Tony Abbott has an economics degree but, being Tony, I doubt that he's a paid-up member of the union; he probably didn't take part. But after his insistence that the NBN be subject to a cost-benefit analysis, we might have hoped that he would apply the same rule to his own policies. Alas, not so.

On Saturday, Abbott pledged to spend $4 billion of our money on three showpiece road projects, with no requirement that they pass a cost-benefit analysis. His Melbourne project was the East-West Link, which failed a cost-benefit analysis when proposed in 2008.

The Gillard government is now paying for the Baillieu government to try to come up with a business case for a revised plan. If it does, fine. But surely our money should not be used to pay for projects that cost more than they're worth.

Labor's cost-benefit rules are far from comprehensive, but they're better than none. It matters because the start of any new government is a chance to improve the rules or make them worse. Abbott is signalling that, under his government, cost-benefit equations won't matter. Politics will rule.

The start of a carbon price is a rare victory for the economists, and the biggest reform by the Rudd/Gillard governments. It culminates a process that began a decade or so ago when Peter Costello, Alexander Downer and David Kemp took a joint submission to cabinet proposing a price on carbon emissions. John Howard rejected it at the time, but finally took it to the 2007 election as policy.

It should not be a left/right issue and, in most of the world, it isn't. Go to Britain, Germany, Sweden, the Netherlands, South Korea or New Zealand, and you will find Abbott's counterparts there are just as committed to carbon pricing as Julia Gillard is. (Britain's Tory PM David Cameron wrote to Gillard last year to congratulate her on the carbon tax, praising it as "a strong and clear signal" to the rest of the world.)

Abbott will destroy it, but future Australian governments, left and right, will bring back carbon pricing, because it is the cheapest, most effective way to tackle global warming, which, if left unchecked, could do immense damage to our world.

A carbon price works because it gives business and individuals an incentive to cut greenhouse gas emissions. Despite the Coalition's claims, it is not an economy-wide tax if it were, it would be far bigger. Rather, it is a tax on emissions from electricity, gas and emissions-intensive industries. It will cost households $10 a week, $5 in electricity and gas bills if we do nothing.

But the beauty of this tax is that you can avoid it, by using less electricity and gas. Of all the options to cut emissions, it pushes us towards making our use of energy more efficient.

There are many ways to do this: turning the thermostat down a degree or so, or the aircon up; replacing energy guzzlers such as plasma TVs or halogen lights with energy-efficient alternatives; just turning switches off. You pay that $5 a week only if you do nothing to adapt.

It's a decentralised, democratic way to reduce emissions: we choose how to do it, in ways that preserve profits and living standards. Treasury and the Productivity Commission had been nudging the Howard government to do it for years. They were right, and had Howard responded in time, it might have been as uncontroversial here as it was in Europe or New Zealand.

Instead, both sides derailed us into bad policies and point-scoring. If energy efficiency is the cheap way to cut emissions, putting solar panels on our roofs and paying excessive prices for the power they generate is one of the most expensive. We've finally realised that now, but the economists warned us from the start.

The politicians gave us gimmicky programs that cost us heaps, but put off the low-cost solution. Both sides used the issue to divide us, rather than unite us behind making a modest but effective start to tackling this potential crisis.

We didn't listen to the economists then. Let's start listening now.

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Two new taxes on the way, don't complain

FEW Australians are aware that we have one of the three smallest governments in the Western world. We complain endlessly that our governments tax too much and spend too much but that is not the way we appear in international comparisons.

The International Monetary Fund estimates that, in 2012, Australia's governments, state and federal, will raise a bit over one-third of our GDP, 34.5 per cent, and spend 36.3 per cent. Of the 34 advanced economies, our revenue is the ninth lowest, our spending the seventh lowest.

That might not sound too flash. But the four lowest-spending countries are Hong Kong (19.1 per cent), Singapore (19.4), South Korea (20.4) and Taiwan (20.9), where your welfare is your responsibility.

Among those with whom we compare ourselves, only New Zealand (33.1 per cent) and Switzerland (34.3) have leaner governments.

But isn't revenue the best comparison, which means the US and Japan are smaller governments than ours? No. Both are running huge deficits as a share of GDP, 7.9 per cent in the US, 9.1 in Japan which will have to be paid for by future taxpayers. Spending, not revenue, is the test of the size of government.

Australia and New Zealand aim to run a Western welfare state while spending far less than other Western countries. The gap between us and them is huge: on average, governments spend 42.2 per cent of GDP in advanced economies, 43.1 per cent in the G7, and 48.2 per cent in the European Union. So far, you would have to say, more spending has not brought more success.

On Sunday, Australia will gain two new taxes. The carbon tax initially will raise $4 billion a year: 0.3 per cent of GDP, rising to 0.4 per cent as it settles in. Revenue from the mining tax can't be estimated accurately, but Treasury puts it at just $3 billion, or 0.2 per cent of GDP, while private-sector economists say it won't even raise that.

Neither tax will change the reality: Australia is one of the lowest-taxed countries in the Western world. If Tony Abbott becomes prime minister next year, as seems likely, he will try to repeal both taxes, and will probably succeed. But it will be only a temporary victory. Both taxes will return, probably in different forms. Both taxes will be levied by future Liberal governments.

You can predict that, because in the past the Liberals have rejected so many Labor reforms, only to adopt them later. Medicare, for example, was initiated by the Whitlam government as Medibank, scrapped by the Fraser government, reinstated by the Hawke government, then embraced proudly by John Howard and his health minister, Tony Abbott.

The Liberals initially fought Aboriginal land rights, only to adopt them once in government. We saw similar feigned anger over the Keating government's Native Title Act, only for the Howard government to adopt it with minor changes. Howard's Liberals opposed compulsory superannuation when the Hawke government introduced it. There are many other examples.

A carbon price is the cheapest way of getting companies and people to make choices that slow the growth in greenhouse gas emissions heating the Earth. Give us a price incentive, and we find ways to reduce emissions with little damage to profits or our standards of living.

The market does this better than governments giving taxpayers' money to companies to do things they would do anyway.

A mining tax is justified because minerals belong to the people, and we deserve a fair share of any super profits made from mining them. The Coalition accepts this argument for oil and gas; the Howard government raised billions of dollars from the petroleum resource rent tax. A future Liberal government will agree that it makes sense to apply a similar regime to iron ore and coal. That is why Liberal governments in resource-rich states have raised royalty rates.

In Victoria, alas, Ted Baillieu does not have that option. And since the High Court interprets the constitution to mean that state governments in effect are forbidden to tax income, tax expenditure or tax production despite the intentions of the founding fathers Baillieu is left with a pack of lousy taxes, mostly on transactions, which are volatile when markets turn down, as now.

The sharp fall in housing sales and prices, flat spending on items carrying the GST, flat jobs growth: state revenue has been hit by a perfect storm. And if you don't have the revenue, you can't pay the salaries.

In 11 years, the Bracks and Brumby governments increased the public service from 23,000 to 37,000. Surely it makes sense for Baillieu to cut it back to 33,000 to help ride out the fiscal storm.

His government is in trouble for many reasons, such as its excessive cuts to TAFE, but cutting the public service should not be one of them.

On most issues, this has been a more moderate and sensible government than it has been given credit for. Its weakness is the one Paul Keating pointed to last week in the Gillard government: it lacks a compelling narrative, a credible explanation to us about what it is doing, and why.

Baillieu became Premier because of his self-discipline, good judgment, a progressive streak, careful planning and willingness to take risks.

Now he must add an ability to communicate, to define his government to us in ways we will endorse. The stakes are high.

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So why aren't we feeling confident?

GLENN Stevens and Wayne Swan want Australians to feel confident about the economy; we refuse. Why?

Look at the fundamentals, our leaders say. In a troubled world, our economy is growing at trend rates. Unemployment is only 5.1 per cent, jobs at record levels. Inflation is negligible. The government has low debt and, with a few fiddles, claims to have a budget surplus. The Reserve Bank's cash rate is near its historical low. So why aren't we confident?

There are many reasons, and we may differ as to how much weight each of them has. They reflect our fears for the future, from the global economy to the carbon tax. They reflect other economic fundamentals that the Treasurer and the Reserve Bank governor are less keen to mention. And they reflect the corrosive impact of the poisonous political partisanship and lack of common purpose in our fast-degrading democracy.

Let's take the global economy first. The narrow victory for the two mainstream parties, New Democracy (right) and Pasok (left), in Sunday's Greek election clears one hurdle facing European leaders. It buys them time to change course and set sail for growth. But Europe is awash with debt: too many governments and banks have taken on too much of it; too much time has been lost by bad decisions; and too many interests remain in conflict. There is a real risk that its great recession will turn into a depression around the world.

Even in Greece, Sunday's vote was anything but a clear mandate. New Democracy and Pasok shared just 42 per cent of the vote, compared to 46 per cent for the four main anti-bailout parties on the far left and nationalist right. Their majority came only from the 50-seat bonus given to the biggest party. The big shift since last month's poll is that the right has regrouped behind the pro-austerity New Democracy, while the left has regrouped behind anti-austerity Syriza, which will now await its time.

Still, a win is better than a loss. It is now up to Germany and the European Union to drop their hard line and admit what everyone knows: that their deficit reduction targets cannot be met by countries in deep trouble, such as Greece and Spain, without taking them into even deeper trouble. Julia Gillard is right: to reduce deficits of this order, you need growth. That requires not only a growth package, but a much slower timetable for deficit reduction.

Most Australians don't spend time thinking about Europe's problems (or those of the US, which by December could eclipse them if Democrats and Republicans can't agree on how to reduce its deficit). We have lost confidence mainly because our real economic situation is less rosy than Swan claims, and because 2? years of non-stop strident partisan politics has corroded confidence in everything: government, opposition and the economy.

Stevens highlighted one key factor. In the past our boat raced along, helped by the tailwind of rapid growth in debt. The ratio of household debt to disposable income almost doubled under Hawke and Keating, from 37 per cent to 70 per cent, and then more than doubled under Howard, to 156 per cent. In 25 years, the amount we owe relative to the amount we earn quadrupled. Some of us have argued for years that this was not sustainable. We now welcome the Reserve Bank to the club as a new member.

Rapidly growing debt felt good. It fuelled our house prices, which created the illusion of rising wealth. Between 1995 and 2005, Stevens said, household assets per head rose by 6.4 per cent a year, mainly due to soaring house prices. As a result, we spent more: on average, each of us bought 2.8 per cent more goods and services every year. And since consumer spending makes up 60 per cent of GDP, that produced strong growth: on average, GDP per head rose 2.5 per cent per head each year.

Contrast that with the years since 2007. In real net terms, the average Australian today owns almost $30,000 less than they did in 2007. Since the GFC sent stock markets crashing, our real wealth per head has shrunk at the rate of 3.25 per cent a year. GDP per head has grown by just 0.3 per cent a year. Growth in real consumer spending per head has halved to 1.5 per cent. Stevens welcomes that as necessary adjustment to the reality that we can't increase debt forever. But, he says, we resent it, and it is primarily that loss of wealth that makes us grumpy.

He is right, but there are two other keys to this story. First, we remain massively in debt. Since December 2007 household debt has grown by a whopping $310 billion. In December 2011, the ratio of household debt to household income was still 150 per cent. Mortgage bills still ate up 11.2 per cent of our disposable income, only slightly less than in 2007. Relative to our incomes, our debt was almost as big as ever and so were our interest bills.

Then shouldn't the Reserve's interest rate cuts lift our spirits? No, because of the banks. Since the end of 2007 the Reserve has cut its cash rate from 6.75 to 3.5 per cent, yet barely half of that has been passed through to households, and even less to small business. The other half has gone to the banks, whose profits, on average, have grown at double-digit rates each year since the GFC began.

Whenever the Reserve cuts rates, the good news is stolen by the banks appearing to grab more for themselves. Some of that was justified, but the bottom line is excessive. Essentially, the banks have looked after themselves, not their clients. So their clients are angry.

Another problem is that there is not one Australian economy any more. Mining is running red hot, some sectors such as health and finance are prospering, but a lot are not. Spending in the mining states is growing at 10 per cent a year. Spending in the south-east, where most Australians live, is growing at 2 per cent, and unemployment is rising. When policymakers ignore the reality around them, people get angry.

Then there is the corrosive effect of Tony Abbott's relentless war on everything Labor does. Politically, it has been very effective; helped by the Murdoch press and some right-wing radio shock jocks, the country's mood outside Victoria now resembles that of 1975. But one of the casualties is confidence in the economy. When Abbott and his troops tell us day after day that the carbon tax will wreck the economy, many people believe him and plan for the worst.

Successful economies tend to be those with a sense of common purpose, where compromise is not a dirty word and opponents are not enemies. Australia had that under Menzies, lost it in the Whitlam years, regained it under Hawke, and has now lost it again. It would help if we could get it back again.

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Good but not that good. The green lights won't last

HOW do we follow up a week like that? For months the economic data here and abroad has been all red and amber lights. Then suddenly we get a wave of green lights, all at once, that seems to clear away the blockages and open up a clear path ahead.

An interest rate cut on Tuesday was followed by the Bureau of Statistics reporting unbelievably strong GDP growth and a sustained rebound in jobs. Then the rest of the world waved us on: China cut its interest rates and announced huge export growth, and European finance ministers agreed to lend Spain up to 100 billion euro($A125 billion) to prevent the collapse of its banks.

If only every week was like that. Then Wayne Swan and the Pollyanna chorus would always be right, confidence would never be short and there would be no point in reading (or writing) columns on economics.

But we know that things are not that simple. We don't usually get waves of green lights sweeping us past every intersection. Good data behind us even if it survives the revisions does not guarantee good times ahead. It's certainly welcome, but while it eases the problems facing Australia and the world in the next 18 months, it does not remove them.

For Australia, the next big test is the introduction of the carbon tax on July 1, along with $2.4 billion of handouts to households in compensation and the school kids bonus. That will be a test of the hyper-emotional, hyper-negative tone that suffocates political debate in these times. Influential forces are trying to derail the tax, and would not mind if they derailed the economy as well.

For Europe, the next big test will be Sunday's Greek election, and the negotiations that will follow, whoever wins, to either rewrite Europe's fiscal austerity pact or remove Greece from the eurozone. At this stage, everyone is taking positions to try to influence the election result. What will happen after it is anyone's guess; the stakes are immense.

Take Australia first. At face value, last week's GDP figures tell us the economy is powering ahead, propelled by robust consumer spending (up 4.2 per cent in a year), quite extraordinary growth in engineering construction (up 53 per cent in that time), strong growth in payrolls (7.4 per cent) and productivity (4 per cent) and booms in sectors from finance to government administration, healthcare, the professions, wholesale trade and agriculture.

Most of that is probably broadly true, if overstated. As I reported on May 11, the Bureau of Statistics has run into technical problems with its jobs data, leading it to overstate jobs growth in 2010 and understate it in 2011 and 2012. Federal and state tax collections confirm that actual job growth has been stronger than the bureau figures show. And that means the economy has also grown more strongly than we thought.

Healthcare and the professions are growth industries. The farmers have had a lot of rain, wholesalers have had a lot of imports. The big banks are shedding staff, but they are also losing market share to smaller banks and non-bank lenders. And migration figures imply that population growth is accelerating.

But there are serious question marks over the two drivers of growth. Growth in consumer spending actually slowed, yet the bureau says that prices have stopped rising, so we've actually hit the pedal to buy more and more. Tell that to High Street.

Even more amazing, it says engineering construction costs are almost flat, despite the mining boom: in the past 3 years they have risen 1.8 per cent (0.5 per cent a year), a sharp change after 24.8 per cent growth in the previous 3 years. Tell that to the Pilbara.

The GDP numbers are likely to be revised down, but to still fairly buoyant levels. The central problem remains: mining is booming while south-eastern Australia is not. In the year to March, spending grew by 10 per cent in the resource states but only 2 per cent in the south-east. The dollar, after three months of welcome falls, has bounced back up to nudge parity with the US dollar. And, like everyone else, our growth depends on what happens in Europe.

The rescue of the Spanish banks buys time for Europe's leaders to negotiate a growth pact, then either exempt Greece from its budget constraints or push it out of the eurozone and risk the fear and uncertainty that would create.

It was a good week for us, and the world, but there are rough times ahead. The best thing is that we are entering this period in stronger shape than we thought. And more than most countries, we are able to make our own fortune.

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The crisis. No place for stunts.

EUROPE is sliding into recession, and the world is sliding with it. That's not all Europe's fault, but its slump will permeate every part of the world economy in some ways, adding to Australia's problems, in other ways, reducing them.

None of us can see through the fog ahead to know how bad it will be. But some things are clear. Each government is focused on its own political needs. No one seems to be in charge of the world economy. We have many politicians, but no statesmen. And we have no consensus on a solution that might work.

The critics were right to warn that Europe's past "solutions" were inadequate to resolve its problems. Instead, the problems have grown. Any solution to them now would be at the cost of the successful countries, and their voters feel they have no responsibility to bail out those in trouble. The path to a resolution is blocked by political deadlock.

The crisis in Europe is the one that could bring down the global economy. But growth is slowing around the world, and the common factor is a loss of confidence.

Last week's job figures confirm that the US recovery has lost its strength. China's housing market is in recession, driving down its manufacturing and steel production, which in turn is driving down prices for Australian coal and iron ore. India, swimming in debt and politically gridlocked, has seen its growth rate slump to a nine-year low.

Australia has its own problems. Each new data set confirms its growth is mostly in mining and related sectors, which are just a sixth of the economy, mostly in Queensland and Western Australia. The mainstream economy in the south-eastern states is at best growing sluggishly, at worst going backwards.

This week brings an avalanche of data, including new figures for GDP, unemployment and the current account deficit. Yesterday we learnt corporate profits have fallen 10 per cent in six months: mostly in mining, from a high level. But in the past two years, manufacturing profits slumped 34 per cent, while manufacturers' unsold stocks rose to an 11-year high. That spells job cuts ahead.

The Bureau of Statistics does not have the data to measure states' output; it just takes an informed guess once a year. But take all the data we do have, and it suggests Victoria, South Australia and Tasmania are all going backwards. Their industries have borne the pain of the higher dollar without the gain of mining investment and boom prices. And at federal level, no one cares.

Interest rates remain far too high. Even after last month's cut, rates for home buyers, small business and depositors are at 2004 levels, when the economy was in a broad-based boom, with growth of 3.75 per cent and adding 265,000 jobs. That is very different to what we are experiencing now, or what lies ahead.

The dollar remains far too high, still 35 to 40 per cent above its 20-year average from 1985 to 2005. Yet for business, the silver lining in Europe's storm clouds has been a fall in the dollar. Since February, it has slid 10 per cent against the US dollar, and 7.5 per cent against all currencies. Unless you are travelling overseas or buying imports, that is good news, because it reduces pressure on businesses that face global competition. If it is sustained, it will save jobs and incomes, and reduce the risks facing the economy.

One of the most important and vulnerable of these is home prices. Many of us might like to see home prices fall, but you would not want to see them collapse. The RP Data-Rismark index reports that the fall in home prices is accelerating at a worrying rate: down in the year to May by 8.4 per cent in Melbourne, and 5.3 per cent nationally. When house prices collapse, they take wealth and consumer confidence with them. Collapsing house prices played a key part in the intensity of the recession in the US, Spain and Ireland. It's another good reason for the Reserve Bank to cut rates today.

We don't know how serious this will become, but it is no time for political stunts. Treasury secretary Martin Parkinson was right when he said on Thursday that in a global recession, Australia has the ability to fight back with both interest rate cuts and budget measures to defend the economy. "Our fiscal position is so incredibly healthy vis-a-vis the rest of the world that we can actually provide stimulus", he said. "We could, if necessary, actually go back into deficit to support activity."

Tony Abbott endorsed this on Friday morning, then backflipped a few hours later to declare that the promise of a budget surplus should have "no ifs and buts". Is he telling us an Abbott government would rather see Australia go into recession than run a deficit? Seriously?

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Memo Coalition: Why our bond yields are falling

LAST week, while our attention was diverted, something amazing happened. In effect, global investors paid the German government to borrow their money and return it in 10 years' time.

Sure, there was a catch. The investors bought inflation-indexed bonds, which means the money they get back in 2022 will have grown to match inflation in the meantime. If inflation in Germany in the next decade is the same as in the previous one, that means if they invest ?10 million ($A12.8 million), they'll get back ?11.675 million. But in 2022, that will buy them only what ?10 million buys them now.

And to park their money like this, investors paid the German government 0.24 per cent of the amount they invested: ?24,000 for every ?10 million. Imagine if the Commonwealth Bank or NAB were to pay us to borrow money from them, and then we eventually pay them back just the amount they lent, plus inflation. Any volunteers?

It shows you how fear has taken over among global investors. They are pulling out of stock markets because they sense they are more likely to lose money there than make it. And they are putting that money in low-risk bonds regardless of how little they pay.

It was not the only coup Germany pulled off last week. It also offered a two-year note, on which it promised to pay no interest at all. Give us ?10 million now, and we'll pay you back ?10 million in 2014; that's the deal. To get investors into this one, the Germans did have to pay a small yield, but just 0.07 per cent. That's value!

Rabobank International strategist Richard McGuire summed it up neatly: "It reflects the now-familiar crisis-induced trend of investors favouring the return of their money over a return on their money."

When confidence is high, investors buy shares or other ventures offering good returns, accepting risk. But in a crisis, as in Europe now, they sell shares and retreat to the safety of the bond market. And there, they lend to governments they know will repay them, not to those offering high returns.

In Europe, pre-crisis bond yields differed little from one country to another. Now the gaps are huge. At last count, 10-year bond yields were 1.37 per cent for Germany and 2.5 per cent for France. But for Italy, they were 5.79 per cent, in Spain 6.32 per cent, Ireland 7.46 per cent, Portugal 12.37 per cent and Greece 29.68 per cent. Countries regarded as safe are issuing debt more cheaply than ever before. Countries in trouble are finding debt either expensive or impossible to issue.

Australia is one of the winners. The Australian Office of Financial Management, which manages the government's debt, has won Risk magazine's global award as sovereign risk manager of the year twice in the past four years. Yields have plunged for Australia's Treasury bonds, inflation-indexed bonds and notes which in turn set benchmarks for yields on bonds issued by Australian companies.

Since 1998, our bond yields have usually ranged between 5 and 6 per cent. But in recent days, the Office of Financial Management issued a new 10-year bond at a yield of just 3.15 per cent, a five-year bond at 2.65 per cent, and a three-year bond at just 2.52 per cent. Yields have fallen by half in a year.

Why? Because global investors have flocked in to buy Australian government debt. Their concern is not that we have too much debt, but too little. IMF figures show that of the 34 advanced economies, Australia has the third smallest ratio of gross debt to GDP: including state and municipal debt, it's just 24 per cent of GDP. By comparison, Germany has a debt-to-GDP ratio of 79 per cent, the United States 110 per cent, and Japan 241 per cent.

The Coalition and its allies are like a broken record warning that Australia is swimming in debt and putting itself in danger. That is simply untrue. Ask yourself: if Labor's borrowing has put us in danger, why is Australia one of only eight countries rated AAA by all three global ratings agencies? Sure, ratings agencies make mistakes, as we all do, but are they that incompetent?

The surge in demand for Australian bonds that has driven yields down has come from overseas buyers. Are these investors incompetent in seeing Australia as a safe bet? No. Rather, the Coalition is using rhetoric to make a dangerous case that doesn't stand up. Australia's debt levels remain very low by world standards. Net debt is expected to peak at less than 10 per cent of GDP here; in Greece, it's about to hit 160 per cent. That's some difference.

The question we should ask is: why aren't our debt yields even lower? Other AAA-rated countries pay far less to borrow than we do. Even the US and Japan, on lower ratings and with critical long-term debt problems, are paying only half to a quarter as much.

The reasons are not clear, but there are several suspects. Because Australia has so little debt, it is less easy to trade, which imposes a premium. Our inflation rate is still a bit higher than in Europe, Japan or the US, which puts a floor under the yield. We are far from the bond traders, and less well known.

And foreign investors are wary of a nation where house prices are so high relative to income, where for 30 years the current account on average has been in deficit by 4 to 5 per cent of GDP, and where banks have a lot of short-term foreign debt, and far fewer foreign assets.

That is what a Coalition government would inherit. It should be thinking about it now.

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We watch as Europe struggles in quicksand

THE immediate future of the global economy, including Australia, now depends on Europe, and whether it can restore confidence to markets. If European leaders can resolve their tangle of problems, growth is ahead of us. If they can't, all bets are off.

Pessimism comes more naturally than optimism. It is now five years since we first heard the phrase "the sub-prime crisis", which rang the end of a golden era of debt-financed growth. Since then, we've had years of recurring crises, summits and resolutions that promised to solve the problems, but haven't.

Australia escaped the damage through a combination of luck, circumstances and good policy. Our banks did not go broke, because the Australian Prudential Regulation Authority did a great job as watchdog, our real estate boom gave banks ample opportunity for growth and, when the crisis hit, the government guaranteed their debts so they could keep borrowing.

The government did not go broke, either. Two decades of asset sales and bipartisan fiscal discipline have made it a net creditor, so it could deliver quick, decisive and well-targeted stimulus measures while maintaining a AAA credit rating. And even bigger stimulus in China saw demand for our exports keep growing in 2009 as the world's exports shrank.

In Europe it was different. To understand where it is now, it's worth taking a look at how it got there.

The euro was born in the '90s as part of the grand vision to create a European government and identity alongside those of the nation states. It promised economic gains: reducing transaction costs, giving business a bigger and more stable market, and creating a currency too big for the speculators to take on. And it has delivered those gains.

But it also brought new problems. Interest rates could no longer be set to fit each country's needs. Countries in trouble would no longer see their competitiveness restored by a falling currency and falling interest rates. And that meant fiscal policy government spending and tax cuts had to do all the work when things went wrong.

Europe's leaders saw that this would require tighter fiscal discipline. As a first step, they agreed to limit their deficits to 3 per cent of GDP, except in exceptional circumstances, and their gross debt to 60 per cent of GDP. Some governments took these goals seriously. Others, including Germany, Britain, France and Italy, did not.

In 1992, when that deal was agreed, the future eurozone had an average government debt of 56 per cent of GDP, and Australia 28 per cent. By 1993 the eurozone's debt crossed its self-imposed 60 per cent threshold, never to return. This year, even with all the austerity, its gross debt will average 90 per cent of GDP, and Australia (including the states) 24 per cent.

Lack of fiscal discipline was one cause of Europe's problems, although only Greece was seriously delinquent. Some countries also resisted reforms. That partly reflects the social conservatism of tribes with a long history low rates of workforce participation by women and older workers in Greece and Italy; shops closed at weekends; pensions at 60 but also shows a lack of political courage to tackle reforms. Even in per capita terms, Europe has grown more slowly than the US or Australia, and tolerated higher unemployment.

But this crisis was caused by Europe's banks. They were big, gullible investors in US sub-prime loans. In many countries, above all Spain and Ireland, they financed real estate bubbles so large they were bound to burst, with devastating fallout. Ireland's banks collapsed, and were bailed out at great expense by Irish taxpayers. In Spain, where one in four home owners now owes more than their property is worth, the banks kept refusing to admit their losses and have lost the trust of investors.

The problems are different in each country. In Greece, government debt is the problem. In Spain, it is the banks. In Ireland, it has become both. And all of them have massive unemployment: 5.5 million people in Spain, almost 3 million in France, 1 million in Greece, 300,000 even in little Ireland. And with their economies going backwards, voters are demanding not more austerity, but growth.

Under the EU's fiscal pact, however, austerity is what they're getting. The pact requires governments to cut their deficits below 3 per cent of GDP by next year. Last year 17 of its 27 members were above that threshold, many of them hugely so Ireland had a budget deficit of 13.1 per cent of GDP, Greece 9.1 per cent, Spain 8.5, Britain 8.3. But they also have very high unemployment and shrinking economies. More austerity will mean far more pain ahead.

The austerity push is driven by Europe's most successful economy, Germany, which is booming due to its state-of-the-art manufacturing industries, especially in machinery. Germany is prepared to add a "growth package" to the austerity pact, which would focus on infrastructure investment and be financed by the EU. There is debate over what more should be done to safeguard the banks. Should the European Central Bank, for example, became a lender of last resort if banks face a run by depositors? Should it invest in the banks when governments lack the capacity to do so and private investors lack the trust?

But on one key question, the EU has not budged. EU President Jose Manuel Barroso has drawn the line at renegotiating the fiscal pact itself, even though its economic (and political) consequences look increasingly dangerous. With all the austerity imposed in Greece, for example, it is running a bigger budget deficit now than when it started, because its economy has shrunk 20 per cent. It's like a dog chasing its tail. You can't generate growth through austerity.

Perhaps the real options will emerge after the Greek election on June 17. The EU and Germany want Greek voters to make it a referendum on whether or not they should stay in the eurozone. But if last week's market plunge continues, or the run on the banks in Greece and Spain gathers strength, time may not be on the EU's side. And it is hard to see where a real solution lies.

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Europe's economic nightmare should worry us

FOR Australia to achieve the government's 3.25 per cent growth forecast, and hence a budget surplus, the global economy will have to remain benign. That really depends on what happens in Europe and, week by week, it looks more unlikely.

Europe is far away, and unless you watch the SBS news it has an unfamiliar cast of characters and issues. But this year it will become more and more important in our lives, so it's worth watching and its scene is changing rapidly. Deficits and debt are one half of Europe's problem. Recession and unemployment are the other. The issue is: which should you tackle first?

German Chancellor Angela Merkel, outgoing French President Nicolas Sarkozy and the European Commission insisted that governments must get their fiscal house in order first, whatever the cost to jobs and growth. And so Europe's governments have locked themselves into a pact to bring their deficits below 3 per cent of GDP by 2013.

But as economists such as Martin Wolf of the Financial Times and Paul Krugman of The New York Times forecast, those austerity measures have led Europe back into recession. So deficit targets have not been met, which requires further austerity measures, which leads to still deeper recession, which . . . well, you get the hang of it.

At the centre of this dilemma is Greece. Through reckless fiscal mismanagement over decades, Greece now has gross government debt of 160 per cent of its GDP (as against 24 per cent in Australia), and an annual interest bill equivalent to almost $100 billion here.

But it is also in an economic depression: its output has fallen by almost 20 per cent, 22 per cent of its workers are unemployed, and an appalling 54 per cent of its young jobseekers.

Which should it tackle first: getting its fiscal house in order, or trying to stimulate growth to provide jobs for its people?

That is what last Sunday's Greek election was about. But in a key complication, no bank will lend to Greece any more. Its only loan sources are the European Union, the European Central Bank and the International Monetary Fund, and (against the IMF's better judgment) they have insisted Greece meet the 2013 fiscal target. Given its economic free fall, that requires it to make another ?11 billion ($A14.2 billion) of spending cuts or revenue hikes: 5 per cent of GDP.

Greece's two main parties had joined forces to try to negotiate a better deal, but failed. The elections saw their combined vote plunge from 77 per cent at the previous election to 32 per cent this time, as voters flocked to parties to the left and right who reject the deal, yet have no realistic alternative. At this stage the elections seem to have left Greece at an impasse, with no viable government, and any new election likely to end in a similar impasse.

But the story has just taken a new twist. Merkel became the most powerful person in Europe, largely because the German public supported austerity, and the opposition Social Democrats had not opposed it until now. But on Sunday, in the Ruhr valley state of North Rhine Westphalia, Germany's biggest, her Christian Democrats were hammered in a state election fought on the issue of austerity, their vote falling to just 26 per cent.

Germany has not suffered the austerity seen in Greece, Spain or Ireland. But German voters objected to council swimming pools being closed as an economy measure. The west is weary of paying endless subsidies to east Germany. And Social Democrat Premier Hannelore Kraft won a personal vote that makes her a potential challenger to Merkel at 2013's federal election.

The trend in German state elections is startling. Since the last federal election, 10 of the 16 German states have gone to the polls: the Christian Democrats have won just two states while being dumped from office in four. They and their partner, the Free Democrats, have shrunk from 515 seats to 399, compared with 590 seats won by the Social Democrats and the Greens.

The crisis in Europe has now seen governments fall in 19 of the 27 EU members, including Britain, France, Italy, Spain and the Netherlands. Tonight Francois Hollande takes office as president of France, then flies to Berlin for dinner with Merkel. Hollande has been ambivalent about whether he wants to rewrite the EU fiscal pact, or just add a growth package to it, by increasing investment. Whatever his goal, he might find Merkel more receptive now.

But even if Hollande can reconcile the contradictions of his campaign promises to meet the deficit reduction targets while increasing spending, there is no good way out for Greece. No Greek government is likely to carry out the spending cuts the European Union requires. Too bad, says European Commission President Jose Manuel Barroso, we won't change the rules for you. And if the EU keeps its hard line, there will be a new financial crisis.

Greece would run out of money to pay public servants. It would have to exit the euro, default on its debts, and bring back a cheap drachma. Markets would speculate on defaults by other countries in strife: Spain, Portugal, Ireland. IMF chief Christine Lagarde warns that this could see a slump worse than the panic of 2008.

A crisis in Europe would convulse trade and financial markets. Australia's banks could face a crisis in rolling over loans. Our dollar would sink. Investments would be put on hold. All bets would be off.

Keep your eye on Europe.

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It's a political budget, a fake budget

THERE comes a point in the lives of governments when they cross a line that is indistinct yet crucial. The ideals and policy goals that they wanted to promote in power start to matter less to them than the desire to just stay in power, whatever it takes.

The Gillard government is now past that point. Yesterday's budget is not about economics, but politics. It sets out to turn a deficit of $44.4 billion into a surplus of $1.5 billion. At face value, that's equivalent to taking 3 per cent of the Australian economy out of circulation. You don't do that for economic reasons particularly when most of the economy is struggling against the effects of a dollar at record highs and interest rates appropriate to boom times. You do it because, in better times, you once promised it and having lost half a million votes through breaking one promise, you don't want to break another. It's all politics.

The measure that best sums up this budget is its biggest one: the $4.75 billion promised to business over four years as a company tax cut will now be taken away, and given to parents. Why? Employers don't vote for Labor. Parents might.

The government had trumpeted the company tax cut as a way to spread around the wealth created by the resources boom. Now it's gone, and this budget offers nothing else to tackle our biggest economic problem: the slump of growth in jobs and output in most of the economy, above all in the south-east, where most Australians live.

The budget's only initiative for Victoria is to take away the money promised to duplicate the Western Highway beyond Ballarat, and spend it instead on a freight terminal in western Sydney. Perhaps Western Sydney has more Labor seats than the Western District.

At first sight, it's hard to see how this budget makes the numbers fit. It seems to be splashing money around, yet it estimates that spending will actually shrink by $7 billion something that last happened when World War II ended. From 25.1 per cent of GDP, on these figures, spending would plunge to 23.5 per cent in 2012-13, and more or less stay there in future. That's on a par with the cuts of Keating and Walsh in the 1980s, and Howard and Costello in the 1990s.

Yet revenue is forecast to increase from 22.3 per cent of GDP to 23.8 per cent. That would be the steepest tax/revenue rise since the double-digit inflation and bracket creep of the Whitlam years. Put them together and the bottom line would go from a deficit of 3 per cent of GDP to a surplus of 0.1 per cent. The last time we saw anything like that was 60 years ago in the original "horror budget", which was designed specifically to slow down an overheated economy.

Where's the austerity? Mostly tucked away in places where it will cost few votes. The four main savings are to cut defence spending ($5.4 billion over four years), scrap the company tax cut ($4.75 billion), slow the expansion of foreign aid ($2.9 billion) and reduce superannuation tax breaks for the super-rich and over-50s ($2.4 billion).

There are some good moves to raise revenue: phasing out the pointless tax break for mature-aged workers, capping tax breaks for medical expenses, and starting to inject some sense into superannuation tax breaks. But there are other savings to regret, backward steps such as scrapping the standard tax deduction proposed by the Henry review, which is the key to freeing ordinary taxpayers from the complexity of tax returns, as well as scrapping the proposed tax break on interest income. Business and investors do badly in this budget.

But in general, this budget is less austere than the dramatic bottom line suggests. That's largely because, as the Coalition points out, many of the "savings" are fiddles, which shift spending out of 2012-13 into 2011-12. We already had lots of them locked in such as carbon tax compensation delivered in May or June when the carbon tax starts in July and this budget has added two more: the first July payment of the Schoolkids Bonus will come in June, as will the 2012-13 grants to local government. As much as $9 billion of spending has been transferred from 2012-13 to 2011-12 to create this budget surplus.

This is important. First, it means the surplus, if it happens, would be a fake, created simply by shuffling payments. But second, it means the budget cuts are less severe than they seem. If the shift is really from a deficit of $35.5 billion to one of $7.5 billion, and if some of it will be replaced by us saving less to spend more, then the real impact on the economy is more like taking out $20 billion.

But that is still a big hit to a weak economy. It makes the budget forecast of 3.25 per cent growth in 2012-13 implausible. And if the economy stays becalmed, even a fake budget surplus will remain out of reach.

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Prepare. Swan's budget nightmare.

IN THIS year of uncertainty, my favourite quote is from fund manager Matt Williams, head of equities with Perpetual Investments. Asked how the global economy would go in 2012, he demurred: ''There are too many moving parts to forecast it all with accuracy.''

On the eve of next week's federal budget, Treasurer Wayne Swan will nod his head. Two years ago, when he pledged to deliver a budget surplus in 2012-13, Treasury's growth forecasts made it seem easy and appropriate.

But those forecasts proved wrong: too many moving parts didn't move as forecast. Now Swan has to deliver a surplus that will be both difficult and inappropriate.

Reserve Bank governor Glenn Stevens, too, might nod his head. The Reserve also got it wrong during 2010 and 2011 by misreading the speed of the economy's various moving parts. Now the RBA is undoing the interest rate rises it so confidently inflicted on us - and waiting to see how much of the intended stimulus gets past the banks to small businesses and households.

Ted Baillieu and Kim Wells might well nod their heads. In short time, Victoria has gone from economic standout to being close to recession. This week's state budget was sound, but not stimulatory. It assumes that Victoria's economy will trough in 2012, then recover during 2013. But for that, those moving parts will have to click together.

And the moving parts that matter most to us might be on the other side of the world.

Tomorrow, there will be two elections in Europe that could make it switch priorities from deficit reduction to growth. At best, this could revive the global economy; at worst it could unleash a new wave of instability that would jeopardise what the International Monetary Fund calls its ''fragile recovery'', and even send the world into a double-dip recession.

One is the French presidential election. If the polls are right, President Nicolas Sarkozy will be defeated by socialist challenger Francois Hollande. If so, that would mean that since the market rout of September-October 2008, 19 of the 27 European Union leaders then in power have been tossed out, along with their counterparts in Japan, Australia, New Zealand, Israel, etc. In that time, only five EU leaders have won re-election.

Sarkozy has been a disappointment to those who hoped he would reinvigorate France, but Hollande's policies are seriously retro. They include undoing Sarkozy's reforms (Hollande wants to lower the pension age from 62 to 60), lifting France's already high minimum wage, lifting state spending (already 56 per cent of GDP, compared with 36 per cent here), putting a 75 per cent tax on incomes over ?1 million ($A1.28 million) - and demanding a renegotiation of the EU fiscal pact to shift priority from reducing deficits to boosting growth.

In Paris, the markets believe that as president, Hollande would quietly shelve some of those policies to focus on renegotiating the European pact. Sarkozy has been the junior partner of German Chancellor Angela Merkel in steering Europe down the path of austerity. The electoral tide is now swinging Europe the other way. In the short term we will see more crises, more negotiations, more summits, and more instability in global markets.

What could be even more important, however, is the result of tomorrow's Greek election. After years of bitter polemic and two changes of government, the traditional rivals PASOK (left) and New Democracy (right) briefly united last year to negotiate Greece's austerity pact with the EU and the International Monetary Fund. That will require even more tough measures to force the Greek budget back into surplus, at a time when the country is in a deep depression.

Greece's GDP fell by 7.5 per cent over 2011, and by 17 per cent since the crisis began. Unemployment has climbed past 21 per cent; among young Greeks, it is 51 per cent. Not surprisingly, Greeks are rebelling; the polls show that new or previously obscure parties opposing the deal could win most seats in the new Parliament. There is no obvious way out; an unravelling of the Greek agreement risks unleashing a market panic like that of 2008.

This is a year of uncertainty. Australia was well-insulated from the 2008 crisis because its banks had lent wisely, the Rudd government moved boldly to shore up household finances and bank liquidity, and China's demand drove coal and iron ore prices sky-high. We remain relatively well-insulated now.

Despite the Coalition's rhetoric, Australia's government debt is very low. Even gross debt is just 24 per cent of GDP, the third lowest in the affluent world. Foreign investors see Australia as a haven, snapping up a net $110 billion of government bonds in the past two years, and driving bond yields to record lows. Almost 80 per cent of Australian government bonds are now held overseas. Yes, that makes us vulnerable to changes in global sentiment. But look around: whatever we do, Australia is not a country the world is likely to worry about.

Our problems are different from Europe's. The one fact that sums them up is that in 2011, in real dollars, mining investment increased by more than GDP. Mining investment is booming, but the rest of the economy is sluggish. The high dollar has flattened much of it. High interest rates and consumer caution have flattened other parts. And the trickle-down from the mining sector is too much of a trickle to kick-start activity.

The dollar is the biggest problem. It raises the cost of doing anything in Australia rather than in the rest of the world. A KPMG study in March found Australia is now the second most expensive business location in the world, behind only Japan. That happens when your currency rises 50 per cent above its long-term level, as Australia's has since 2005. If you're buying anything overseas - holidays, goods on the internet, machinery - it's a blessing. If you're trying to do anything here that competes with anything done overseas, it's a disaster. And the dollar will remain high as long as the world sees us as a haven.

Even BHP and Rio Tinto are now considering shelving big mining projects here, in part because the high dollar has inflated their cost in global comparison. Mineral processing has boomed, but the output of the rest of Australian manufacturing has slumped 7.5 per cent since the GFC, costing more than 100,000 jobs. Those who tell you manufacturing is doing well are seriously uninformed.

The growth pace of the economy in the second half of 2011 was just 2.5 per cent. There are signs that the slowdown might have bottomed. We are told that next week's budget will forecast growth to accelerate to 3.25 per cent in 2012-13. Indeed, Swan is talking as if the mere forecast is already an achieved fact. Not so - and the risk that it will not be achieved could become his nightmare over the year ahead.

Why? Because the budget usually forecasts growth to be 3.25 per cent or thereabouts. That doesn't mean that's what we get. Two years ago, the budget forecast growth of 3.25 per cent, but we ended up with just 2 per cent.

The budget forecasts were good in the good years, but in the past four years, they have been way out. In 2008-09, 2010-11 and 2011-12 they forecast far more growth than we got, while in 2009-10 they did the reverse. Too many moving parts!

There's a big risk that this forecast will again prove too optimistic. Mining investment could fall well short of the $120 billion forecast. The budget itself will slow activity: even with all the fiddles, you can't take $40 billion out of this economy without it putting a brake on growth, particularly where it is already weak. With the world recovery fragile, state governments also cutting spending, business and consumer confidence subdued, and the banks passing on only about half the Reserve Bank's rate cuts, it's difficult to see where that growth will come from.

If growth falls short, then the budget too will fall short of its target. Swan could be forced to play catch-up, tightening spending again and again in a low-growth economy to ensure that his political target of a budget surplus is met. Those moving parts are unpredictable.

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Bravo Hockey, for a speech free of cheap hits

JOE Hockey went to London last week to give a speech declaring ''The End of the Age of Entitlement''. Pity he didn't also go to Washington, to listen to the biannual meetings of the International Monetary Fund and the World Bank.

Within 18 months, Hockey is likely to be Australia's next Treasurer. If he is, he will face a very challenging task in reconciling the Coalition's rhetoric and the expectations it has aroused with the limited resources he will have to meet them.

The Coalition's economic policy, we are told, is to cut taxes - cut personal income tax, cut company tax, scrap the carbon tax, scrap the mining tax - while putting the budget back into a fiddle-free surplus, and increasing some spending.

Uh-huh. Labor claims that would require $70 billion of spending cuts over four years - roughly 5 per cent of budget spending - which the Coalition refuses to spell out at this stage. You can understand why, but after Treasury found $11 billion of holes in its 2010 campaign promises, the silence leaves the Coalition's economic team short on credibility.

Hockey clearly understands this, and his speech set out to tackle it. It will be dismissed by some as another gaffe by a bloke who is likeable but gaffe-prone. A shadow Treasurer implying that he wants to cut welfare entitlements? When the Howard government reaped such an electoral harvest from expanding them?

Abbott quickly told us that Hockey was talking only about Europe, declaring: ''Australia hasn't got there yet, and it's the job of the Coalition to ensure that we never do''. Yesterday Hockey fell in line, as if to put an embarrassing episode to rest.

I hope it doesn't. In London, Hockey gave the kind of speech you wish our political leaders would give, but, with the exception of Malcolm Turnbull, rarely do. It was well-argued, full of ideas, largely bereft of cheap point-scoring, and confronted a real problem that will loom large over Australia and the rest of the West as their populations age.

You can read it on joehockey.com. It was not just about Europe - ''Australia has not completely avoided the problems'', Hockey declared, while praising the Future Fund and four Labor initiatives that reformed our retirement system. It summed up powerfully the forces that caused Europe's fiscal problems, and which our governments too must contend with. The key problem, Hockey said, is ''a belief that one person has a right to a good or service that someone else will pay for ? In our collective effort to win votes, political leaders deliberately portray a new spending commitment as if it is coming out of their own personal bank account. Political leaders rarely thank taxpayers for funding the policy.

''The sovereign debt problems we are seeing in Europe and the US today are the outcome of countries wanting a lifestyle they cannot afford, but are quite happy to borrow from others to pay for ? Whether it is defence, law and order, income support, social programs and so on, the outcome is the same. Eventually the piper has to be paid.'' Too true. Witness the culture in our tabloids, talkback, even in letters to The Age, that berates governments for spending too little, taxing too much, and not running a surplus. We forget arithmetic - and we forget that governments don't spend their money, they spend ours. In turn, we receive what that spending buys for us: education, health, a welfare safety net, transport, security. As former US Supreme Court Justice Oliver Wendell Holmes famously put it: ''I like to pay taxes. With them, I buy civilisation.''

Hockey wound up: ''The bottom line is that our communities need to make a tough decision. We cannot choose both higher entitlements and lower taxes. We must make a decision one way or the other. We can take more and more of our citizen's money and spend it for them, or we can take less of it and rationalise government services.''

Hockey chose the latter. ''We must rebuild fiscal discipline. Budget surpluses must be restored, ideally until the debt is repaid.'' He urged increasing the pension age, means-testing ''all government-funded pensions and other such payments'', making superannuation compulsory, requiring user co-payments for some government services, citing health care - and eliminating public debt.

You don't have to accept all his argument or prescriptions (particularly the last) to find them refreshing to read. At last, here is a politician talking frankly in public about the real difficulties policymakers face. Wayne Swan would be a far more effective Treasurer if he did the same.

But Swan was in Washington, where he too performed a PB: giving a speech to the IMF that did not boast that Australia is doing better than any of them (perhaps because IMF data shows it isn't).

Ideally, Hockey should have gone with him, to absorb the IMF's key message: give growth and jobs priority now, and allow time to get budgets into surplus over the medium term. IMF data shows Australia has very little debt by global standards - and Hockey knows that half our economy is in or close to recession.

Why doesn't the Coalition back the IMF's message, and oppose Labor's plan to force the budget into surplus by slashing spending and raising revenues? Hockey's speech implies one reason: they're fiscal hardliners. But is it also a cynical tactic, to close off Swan's options so the ensuing economic pain costs Labor votes?



THE END OF THE AGE OF ENTITLEMENT

JOE HOCKEY ADDRESS TO THE INSTITUTE OF ECONOMIC AFFAIRS

17 APRlL 2012, LONDON

Introduction

I wish to thank my friends at the Institute of Economic Affairs for the opportunity to discuss an issue that has been the source of much debate in this forum for sometime….that is, the end of an era of popular universal entitlement.

There is nothing much new in the debate other than the fact that action has now been forced on governments as a result of the recent financial crisis. Years of warnings have been ignored but the reality can no longer be avoided.

Despite an ageing population and a higher standard of living than that enjoyed by our children, western democracies in particular have been reluctant to wind back universal access to payments and entitlements from the state.

As we have already witnessed, it is not popular to take entitlements away from millions of voters in countries with frequent elections.

It is ironic that the entitlement system seems to be most obvious and prevalent in some of the most democratic societies. Most undemocratic nations are simply unable to afford the largesse of universal entitlement systems.

So, ultimately the fiscal impact of popular programs must be brought to account no matter what the political values of the government are or how popular a spending program may be.

Let me put it to you this way: The Age of Entitlement is over.

We should not take this as cause for despair. It is our market based economies which have forced this change on unwilling participants.

What we have seen is that the market is mandating policy changes that common sense and years of lectures from small government advocates have failed to achieve.

And we have subsequently witnessed over the last twelve months a raging battle. This has been a battle between the fiscal reality of paying for what you spend, set against the expectation of majority public opinion that each generation will receive the same or increased support from the state than their forebears.

The entitlements bestowed on tens of millions of people by successive governments, fuelled by short-term electoral cycles and the politics of outbidding your opponents is, in essence, undermining our ability to ensure democracy, fair representation and economic sustainability for future generations.

Perhaps we could re-apply noted British philosopher, AC Grayling’s words on liberty to our debate by declaring that we may record that the age of entitlement might have passed its best point, “after so brief a period of flourishing…”

And flourish it did.

Government spending on a range of social programs including education, health, housing, subsidised transport, social safety nets and retirement benefits has reached extraordinary levels as a percentage of GDP.

However an inadequate level of revenue has forced nations into levels of indebtedness that, in an age of slowing growth and ageing population, are simply unsustainable.

The social contract between government and its citizens needs to be urgently and significantly redefined. The reality is that we cannot have greater government services and more government involvement in our lives coupled with significantly lower taxation.

As a community we need to redefine the responsibility of government and its citizens to provide for themselves, both during their working lives and into retirement.

As part of this process, we must emphasise that government spending should be funded from revenue rather than by borrowing from future generations in whatever form that may take.

The Problem

Entitlement is a concept that corrodes the very heart of the process of free enterprise that drives our economies.

All of us would agree that there are some basic community entitlements. For generations we have all sought to define those basic rights.

For example, in the United States constitution the founding fathers determined that citizens are entitled to life, liberty and the pursuit of happiness.

You will remember it was Margaret Thatcher who interpreted community entitlements as the right for our children to “grow tall and some taller than others if they have the ability in them to do so”.1

This broader and timeless conservative definition of our end game lays down some foundations for the role of government.

Equality of opportunity rather than equality of outcome is my preferred model for contemporary society.

Thankfully the modern capitalist economy is centred around the satisfaction of personal wants and needs. Commercial transactions are at the core of the system. And it is a simple and proven formula for willing buyers to engage with willing sellers. If we want a product or service we go and buy it with the dividend from the fruits of our own labour. The producer is happy and the customer is satisfied.

The problem arises however when there is a belief that one person has a right to a good or service that someone else will pay for. It is this sense of entitlement that afflicts not only individuals but also entire societies. And governments are to blame for portraying taxpayer’s money as something removed from the labour of another person.

In our collective effort to win votes, political leaders deliberately portray a new spending commitment as if it is coming out of their own personal bank account. Political leaders rarely thank taxpayers for their funding of the policy.

To pay for all these good policy initiatives, governments have taken the easy option and borrowed money from that mysterious and amorphous group defined as “bondholders”.

We all know this is simply a case of borrowing money from the taxpayers of tomorrow for spending initiatives of today. Of course I say with irony, it gets even better when some governments borrow more money to pay the interest on current debt so existing taxpayers and voters will never notice the pain. This is the public sector equivalent of those much maligned ponzi schemes.

The sovereign debt problems we are seeing in Europe and the US today are the outcome of countries wanting a lifestyle they cannot afford but are quite happy to borrow from others to pay for.

Of course in recent months in some countries in Europe the “borrowings” have turned into permanent transfers of wealth as those countries have become unable – or unwilling – to repay the loans.

Richer countries are either writing off the debt of poorer countries or they are subsidising the debt repayments with sophisticated transfer payments.

As a parent I want to give my children everything they wish for.

As a democratically elected legislator I want to give my constituents everything they wish for.

The hardest task in life is to say NO to someone you care about.

So perhaps what we are witnessing is a chronic failure of the democratic process.

A weak government tends to give its citizens everything they wish for. A strong government has the will to say NO!

Being profligate is easy and politically popular in the short term, particularly when the political cost of raising sufficient revenue is avoided by resorting to debt.

But painless revenue makes for reckless spending.

Whether it is defence, law and order, income support, social programs and so on, the outcome is the same. Eventually the piper has to be paid.

Since World War 2 western communities have enjoyed prosperity that has exceeded all expectations. This has been fuelled by innovation, materialism, globalisation, free trade and debt.

Of course these are not malevolent developments. Rather they are the lauded natural outcomes of a free and successful society.

Moreover these initiatives, which have fuelled a massive improvement in global economic productivity, have driven the age of prosperity. Arguably this has delivered the most dramatic improvement in the material quality of life since the beginning of humanity.

In effect the rapid rise in private prosperity has been matched with demands for an equal improvement in state provided prosperity.

This is understandable. We all want the best available health care, the best education, the best pharmaceuticals and so on.

The difference is that the handbrake on private demand is income.

Unless a consumer can borrow money, it is their income and wealth which determines whether they can buy a new television or renovate the family home.

But for governments with seemingly unlimited capacity to borrow money, that handbrake on expenditure is not real.

While the Keynesian model of Government-led stimulus during the inevitable downturns in the economic cycle is well documented, governments who have turned on the fiscal tap seem completely incapable of turning it off when the cycle turns upwards.

So we have witnessed a continual over-commitment in many countries, funded by the lure of cheap and easily obtainable debt.

It is a problem which is not new. We might think by now we would have learnt the lessons. But clearly that is not the case.

A Tale of Two Systems

In September last year I travelled to Hong Kong – a city of 7 million2 - which sits at the edge of the Pearl River Delta - home to over 100 million additional residents. As a Special Administrative Region, Hong Kong is now serving as a conduit between China and its global trading partners, particularly those with business directly to the north.

So even though its destiny has changed, Hong Kong continues to maintain its own currency, laws and Parliament but is now totally wed at the hip to Beijing.

Without a social safety net, Hong Kong offers its citizens a top personal income tax rate of 17% and corporate tax rates of 16.5%. Unemployment is a low 3.4%3, inflation 4.7%4 and the growth rate still respectable at over 4%5. Government debt is moderate6 and although there is still poverty, the family unit is very much intact and social welfare is largely unknown.

The system there is that you work hard, your parents look after the kids, you look after your grandkids and you save as you work for 40 years to fund your retirement. The society is focused on making sure people can look after themselves well into old age.

The concept of filial piety, from the Confucian classic Xiao Jing, is thriving today right across Asia. It is also the very best and most enduring guide for community and social infrastructure.

The Hong Kong experience is not unusual in Asia. Characteristics such as low inflation, low unemployment, modest government debt, minimal unfunded benefits and entitlements, and significant growth are powering a whole range of emerging markets and developing an Asian middle class that will grow to some two and a half billion people by 20307.

The sense of government entitlement in these countries is low. You get what you work for. Your tax payments are not excessive and there is an enormous incentive to work harder and earn more if you want to.

By western standards this highly constrained public safety net may, at times, seem brutal. But it works and it is financially sustainable.

Contrast this with what we find in Europe, the UK and the USA.

All of them have enormous entitlement systems spanning education, health, income support, retirement benefits, unemployment benefits and so on. Some countries are more generous than others and in many instances the recipients of the largest amount of unfunded entitlements are former employees of the Government.

In all these areas people are enjoying benefits which are not paid for by them, but paid for by someone else – either the taxes of those who are working and producing income, or future generations who are going to be left to pay the debt used to pay for these services.

Despite tax rates much higher than in Hong Kong, government revenue in these economies still falls well short of meeting current government spending initiatives.

The difference is made up by the public sector borrowing money. And more often than not we are borrowing money from people such as the citizens of Hong Kong.

You would have to say that this is a flawed formula. For western democracies the party is over.

Our most deeply exposed western economies can no longer continue to accumulate debt without constraint. The ongoing credit crisis in Europe seems a very long way from resolution. Ultimately, spending on entitlements becomes a structural problem for fiscal policy.

In the United States for example, the excess of government expenditure over receipts is enormous. The Government has $15 trillion of Federal gross debt and it’s going up by $1.5 trillion a year because expenditure is $6.2 trillion a year and receipts $4.8 trillion8. Obviously with interest rates at near zero levels the cost of debt is limited but sooner or later it must end in tears.

So why is it that western nations are so deeply indebted and so tragically unfunded when it comes to meeting their future obligations in the face of an ageing demographic and longer life expectancies?

Both sides of the western political spectrum are to blame.

As the electoral pendulum has swung between socialist and conservative sides of politics, the socialist governments, often winning electoral success thanks to the funding from unions, have created a huge array of entitlements for selected classes of individuals, particularly and ironically employees of government and members of unions.

These entitlements have now begun to hang like a millstone around the neck of governments, mortgaging the economic future of many Western nations and their enterprises for generations to come.

I will give you a classic example. In Boston USA, there’s a certain former police captain who retired aged 55 some 20 years ago after a 32 year career on the force. During that period he managed to contribute some $73,000 to his defined benefit pension plan, a plan which gives you a percentage of your salary for life when you retire. On retirement he started receiving 100% of his retirement salary, namely $55,000.

He is now 75, which means he has collected some $1.1 million in benefits. And it looks like he’ll live until he’s at least 90 or even older, so that’s almost another $1.0 million over 15 years. It’s more than he earned in 32 years and he contributed just $73,000 to help pay for it. Either taxpayers pay the bill or the government has to borrow to pay for the entitlement.

When the electoral pendulum swings, conservative governments have come in promising to fix the problem but in most instances have just trimmed around the edges without addressing the real problem of the growing entitlement burden.

And the greatest Catch 22 of modern democratic politics is that socialist governments are blindly wedded to increases in expenditure while conservative governments are blindly wedded to not increasing taxes. So once the cycle of economic growth comes to its inevitable end, the problem is exacerbated.

Perhaps the real problem is the exuberant excesses of politicians who do not seem to understand or care about the fact that like a household, a nation needs to balance its budget over time and needs to make sure it can cover its future commitments.

This has already reached dangerous levels with some OECD countries like France spending close to 30% of their GDP on public social expenditure.

Other countries get by with much less. Korea only spends 10% of GDP on public social expenditure with Australia at 16% of GDP, the USA at 20% and the United Kingdom at 23%.9

The bottom line is that our communities need to make a tough decision. We cannot choose both higher entitlements and lower taxes. We must make a decision one way or the other. We can take more and more of our citizen’s money and spend it for them, or we can take less of it and rationalise government services.

But it is a decision that must be made …and soon.

This challenge is compounding in scale as an ageing population in many industrialised countries is making even further demands on the entitlement system.

Europe for example, has the highest proportion of over 60s of any region in the world. And while 22% of the population in Europe is currently over 60, this number is forecast to rise to 35% by 2050.

Plans for the future of Europe have assumed strong economic growth, but it is highly uncertain how growth will be achieved as the fiscal burden associated with rising health and aged care costs, as well as a generous pension scheme, continues to grow.

According to a study commissioned by the European Central Bank10, 19 EU countries had almost 30 trillion Euros of unfunded entitlement obligations for their existing populations. Of this 30 trillion Euros, France has liabilities of 6.7 trillion and Germany 7.6 trillion.

These liabilities will continue to grow without significant reform. And, by the way, I don’t see how a debate in France about lowering the retirement age from 62 to 60 will help address these challenges.

A lower level of entitlement means countries are free to allow business and individuals to be successful. It reduces taxation, meaning individuals spend less of their time working for the state, and more of their time working for themselves and their family.

An economy that impedes individual ambition - whether through higher taxation, the lack of opportunity in employment, or restricted social mobility - is one that enforces the barriers of class, rather than reduces them.

Governments should ensure that the actions they take will leave their citizens better off because, naturally, that will reduce the desire for ‘entitlements’. The role of government must be to help people to the starting line, while accepting that some will then run faster than others.

Everyone should know that they grow up in a country where it is possible, through hard work and diligence, to achieve their dreams.

Naturally the Americans call this the American Dream, but it is similarly played out across the globe, including in emerging economies in Asia.

The Australian Experience

As the child of a father who came to Australia in 1948 as a refugee from Palestine and built himself into a successful businessman, I know that being successful in Australia is not the product of belonging to rich and prosperous families, but rather is the result of hard work and diligence.

In fact those stories are most often repeated in countries without extreme interventionist governments. For example, over 80 per cent of the millionaires in the United States are the first generation in their family to be millionaires.

But Australia has had its fair share of irresponsible governments. In 1996 the incoming conservative government inherited a budget in a weakened state. The previous Labor administration had racked up a succession of budget deficits and $96bn of net debt, about 17% of GDP. (I know that figure is not large by the current experience of most countries in Europe, but trust me, the repayment task was a challenge.)

It took nine years of budget surpluses and asset sales to repay the debt. That is three election cycles in Australia.

It took another two years of hard fiscal rectitude to build up a stock of net assets equivalent to 4% of GDP. In total that is a long period of sustained fiscal austerity.

Australia has not completely avoided the problems of other western democracies because it still has a lot of spending by government which many voters see as their entitlement.

However, over the years there have been a number of key decisions to reduce spending to manageable levels.

Australia has sought to reduce the burden on government of providing aged pensions through a compulsory system of savings for retirement. Retirees must rely first on the benefits they have accumulated rather than on government income support. And retirement benefits to government employees and politicians are no longer provided on a defined benefit basis but on a contributions basis so they only get back the principal and earnings on what they have put in.

The government is also gradually raising the age at which government benefits can be accessed, from 60 to 67 for women and from 65 to 67 for men from 1 July 2023.

Most importantly, the net government assets of $45 billion arduously built up by the previous conservative government were set aside into a Future Fund. The funds cannot be touched by the government for everyday expenditure. Rather, the fund can only be accessed to pay for the previously unfunded entitlements of federal public servants so as to reduce the burden on taxpayers.

That was an initiative of great foresight. It is, if you like, Australia’s sovereign wealth fund with the explicit purpose of boosting the sustainability of the budget through time.

The Road Back

So where do we go from here?

There is really only one solution in the long term, and that is for countries to live within their means.

We must rebuild fiscal discipline. Budget surpluses must be restored, ideally until the debt is repaid.

This can only be achieved by cutting spending or by raising taxes. And given the general acceptance that the increased drag from higher taxes would compromise economic growth, the clear mandate is to lower expenditure.

This is lovely rhetoric but to actually do it needs some very harsh political and social decisions.

To be bold, I have some suggestions.

The first is that people need to work longer before they access retirement benefits. When the age pension was introduced in Australia at age 65, life expectancy was 55. Today life expectancy is in the 80’s.

So you can understand how I was shocked to hear that one of the policy promises of one of the main French Presidential Election candidates, François Hollande, is to bring the official retirement age back down to 60 from 62.

Second, there have to be universal compulsory retirement schemes into which employees and employers must contribute so that after a man or woman has worked for 40 or more years they have set aside an amount that can provide them with a reasonable income for a further 15-20 years at least.

Defined benefit schemes need to be phased out worldwide, including in Australia, whether they are for public servants or private sector employees. In addition, all government funded pensions and other such payments must be means tested so that people who do not need them do not get them.

Third, there needs to be clear thinking about which services should be provided by governments and whether government funded services should be entirely free or have some affordable co payment. Many will argue that certain government services should be free and universal but the problem with any free good is that it will be overconsumed and underappreciated.

For example, in Australia, health services are partly funded through compulsory levies, paid either to the government or to private health insurers.

Across the Western world we have saddled our nations and our children with a debt burden that is simply unsustainable. It is time for strong political and economic leadership to clean up this mess properly, not with a series of band aids and political spin but with genuine economic and social reform.

The age of unlimited and unfunded entitlement to government services and income support is over. It’s as over in Greece as it is in Italy, in Spain, and in the USA.

There also needs to be a rethinking of government borrowing. Some might argue that some low level of debt is not a bad thing. I believe that is a dangerous proposition. Once some level of debt is accepted it becomes too tempting to opt for just a little more. Pretty soon a little debt becomes a big problem.

Also, there is a significant cost to servicing debt. Even in Australia, where net debt as a percentage of GDP is lower than in Europe, interest costs on net debt are approaching $7 billion a year. That is enough to build 7 new teaching hospitals every year.

The message is that every dollar of debt has an opportunity cost.

Another aspect of the problem is that credit is no longer easily accessible for the private sector or the public sector.

And the credit market no longer automatically favours the public sector. Ironically more and more sovereigns are seen as a greater credit risk than many international companies. I would think the experience of the past few years has been something of a reality check. Lenders now know that even today advanced western economies can default on their debts.

In today’s global financial system it is the financial markets, both domestic and international, which impose fiscal discipline on countries. A country which is viewed as approaching its safe limit for debt will find it increasingly difficult to borrow additional funds at an affordable rate. Eventually the capital markets will close.

We are now in an era where lenders are much more wary about credit risk. I view this as a healthy development.

Lenders have a more active role to play in policing public policy and ensuring that countries do not exceed their capacity to service and repay debt.

This is playing out most dramatically in Europe where the European Commission and the European Central Bank are either directly or indirectly heavily influencing public policy in Greece, Italy, Spain and Portugal to name a few.

It is also worth noting that the system of regulation of banks and other deposit taking institutions is artificially boosting demand for sovereign credits with mandated liquidity requirements generally emphasising a prominent role for government securities.

Governments have been too prepared to exploit the resultant lower borrowing costs.

And whilst securities issued by sovereigns have traditionally been viewed as the safest and most liquid assets, I am not sure that it is still the view of investors in Europe today.

Concluding Comments

The road back to fiscal sustainability will not be easy.

It will involve reducing the provision of so called “free” government services to those who feel they are entitled to receive them.

It will involve reducing government spending to be lower than government revenue for a long time.

It is likely to result in a lowering of the standard of living for whole societies as they learn to live within their means.

The political challenge will be to convince the electorate of the need for fiscal pain and to ensure that the burden is equally shared.

Already in the UK and parts of Europe we have seen the social unrest that can result when fiscal austerity bites.

But the alternative is unthinkable.

The Western world cannot continue on its current path of borrowing to fund its excessive lifestyle. The problem of fiscal sustainability will only get worse.

Eventually lenders will cry enough is enough and turn off the credit tap. And when that happens the economic, financial, social and political dislocations are likely to be catastrophic.

The Western world is at the most important economic cross road in its history - Governments must accept their responsibilities to fiscal discipline and the prudent use of their citizens hard earned monies, or they need to accept that the demise of western economies will be forced upon them in a dramatic, unpredictable and possibly violent way.

Adam Smith’s free hand is perfectly capable of forming a fist to punish nations who ignore the fundamental rules. Unfortunately I think Adam’s down at the gym right now and in training for one almighty whack.

Restoring fiscal credibility will be hard. But it is essential we learn to live within our means.

The Age of Entitlement should never have been allowed to become a fiscal nightmare. But now that it has, Governments around the world must reign in their excesses and learn to live within their means. All of our futures depend on it.


[1] Speech to the Institute of Socio Economic Studies “Let Our Children Grow Tall” September 15, 1975

[2] World Bank

[3] February 2012

[4] ibid

[5] GDP year to Q3 2011

[6]Gross debt of 33.8% GDP in 2011, IMF World Economic Outlook Database, September 2011

[7] Can the Asian Middle Class Come of Age?, Homi Kharas, The Brookings Institution, 12 June 2011

[8] IMF, World Economic Outlook, September 2011

[9] OECD Social Expenditure Database, estimates for 2012

[10] Pension obligations of government employer pension schemes and social security pension schemes established in EU countries, Final Report, European Central Bank, January 2009



LETTER TO THE EDITOR APRIL 25, 2012

TIM Colebatch forgets to mention that Joe Hockey voted against means testing the private health insurance rebate, which will stop workers on low incomes subsidising the health insurance of wealthy people. He doesn't mention Mr Hockey's Rolls-Royce paid parental leave scheme that provides massively higher benefits for wealthy Australians than it does for Australians on average incomes. Nor does he mention that Mr Hockey will jack up tax rates for companies and small businesses, while giving a huge tax break to people like Clive Palmer and Gina Rinehart. Further, it was very strange there was no criticism of Mr Hockey's calls for massive cuts to spending on the social safety net.

Treasurer Wayne Swan, Canberra, ACT

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