Melboure. It's a town of services, not manufacturing

MELBOURNE'S future is here. In the past decade, new professional services firms have mushroomed in inner Melbourne, becoming the state's strongest source of growth in private sector jobs, a conference on Victoria's future has been told.

The Victoria at the Crossroads conference, co-sponsored by The Age, heard that new firms in Victoria's two fastest-growing industries finance, and professional and scientific services are overwhelmingly choosing to set up in the CBD and inner suburbs, in the buzz of the city.

By contrast, new workplaces in transport, warehouses and wholesale trade are springing up in outer western and northern suburbs, along the Western Ring Road, Professor Bruce Rasmussen of Victoria University said.

These clusters of emerging industries hold the key to Victoria's future producing food, services and tourism, and education opportunities for the booming economies of Asia conference speakers agreed.

The secretary of the Department of Business and Innovation, Howard Ronaldson, said new infrastructure such as a Melbourne metro and the east-west link "is arguably the biggest single factor that will make us more productive".

Mr Ronaldson said most big cities now have metro systems, freeing up inner-city road space for commercial vehicles. Melbourne should do the same, he said: "It's a fair bet that most of the high-value-added jobs will be generated in and around the CBD. One of the big demographic shifts recently has been that close to half of all Melburnians live in the suburb they work in, or close to it."

The conference was convened by Victoria University, the Committee for Melbourne and The Age after the high dollar and high interest bills sent Victoria's economy sliding on a wide range of indicators: jobs, investment, retail and housing.

It ended, however, with a consensus that while the high dollar had created real problems for the state in the medium term, its long-term future looked good after a decade of strong growth in knowledge-intensive industries.

"When the Chinese no longer pay as much for iron ore and coal, what will we sell to the Chinese and other middle-class consumers to our north?" asked economist Saul Eslake, of Merrill Lynch. "The answer is likely to be: agricultural commodities, and commercial and personal services. Victoria is better placed than many other states to cater for the likely sources of export demand in the next 20 years."

Also at the conference, Prime Minister Julia Gillard lashed out at the Baillieu government's $300 million cut to TAFEs, using a speech on the Victorian economy to call it "crazy" and a threat to the state's competitiveness.

Ms Gillard also rejected suggestions from business and commentators that industrial relations reform was a "magic bullet" for boosting productivity, instead nominating strong education and training as a far more powerful avenue.

But Ms Gillard did not address demands for more Commonwealth infrastructure spending in Victoria, including calls from state Treasurer Kim Wells to bring money to the table for the east-west road tunnel project.

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CSL. The science experiment that paid off

At 33, Brian McNamee was chosen to run the Commonwealth Serum Laboratories: a small government enterprise manufacturing plasma, antibiotics, flu vaccines and other medicaments for Australia and its neighbours.

This week CSL announced its first $US1 billion ($954 million) global profit for 2011-12. It is now Australia's most successful manufacturing business, and by a long way.

While CSL too is being belted by the high dollar, the annual earnings report a "foreign currency headwind of $108 million", its global structure, with manufacturing plants in four countries, its high productivity and premium products have allowed it to withstand those headwinds, and remain highly profitable. (Its $US1 billion profit was achieved on just $US4.6 billion of sales.)

It has been an amazing journey that few would have expected when, in late 1989, the industry minister John Button headhunted the young McNamee to become director of CSL, with the ultimate aim of privatising it to be a flagship for the fledgling Australian pharmaceutical industry.

It is an unusual story, of a most unusual company, in which the cultures of the scientific researcher and the corporate carnivore have somehow merged to create an enterprise that in some ways defies modern fashions and in other ways anticipated them.

It is now very much a global company, on the verge of becoming one of the world's top 20 pharmaceutical companies, and with 90 per cent of its revenues coming from outside Australia. Yet it is based in an unpretentious old building in Melbourne where CSL has been since 1918. Its head office has only about 20 staff.

Its big markets are the US and Europe, with a fast-growing trade in Asia. But it is led by an Australian-dominated board, chaired by molecular biologist Professor John Shine, carries out half of its vast research and development activity in Melbourne, employing 400 to 500 researchers, and credits Australian research for much of its global revenue.

It is not just McNamee who has been with the company for decades. Most of his senior executive team have also been there for decades, either with CSL itself, or in the companies it has acquired. McNamee's main interest is in strategy, and he is happy to delegate and trust his deputies. In conversation, he habitually uses "we", not "I", to explain his thinking. For a top 20 company, it sounds remarkably collegial.

"People think we're scientists bubbling away with test tubes", he says with self-deprecation. "But we think we're also pretty good at business. We've been financially conservative but, operationally, very bold and aggressive."

McNamee always envisaged CSL becoming something like this. His goal, he says, was to create "a great Australian company". He's done that, and after 23 years at the helm, plans to hand over in July next year to Paul Perrault, now head of CSL Behring, its Philadelphia-based plasma subsidiary.

A doctor by training, McNamee drifted into pharmaceuticals in his 20s, while in Germany after a brief try at emulating his brother Paul on the professional tennis circuit. At 27 he was recruited back to Australia by Fauldings, helped Button draft the "Factor f" pharmaceuticals industry plan, then ran Pacific Biotech before being conscripted to CSL.

From the outset, McNamee set his sights on building a global business, created by specialising, building scale, innovating, exporting - and making strategic takeovers. They began at small scale, even before CSL was floated on the stock exchange in 1994, valued at $300 million. It is now valued at about $20 billion.

"Most of Australia's assets are stressed: small assets, low scale", he says. "It's either get bigger, or get out. You either consolidate, or get consolidated. We elected to be the consolidator."

CSL developed its expertise in mergers and acquisitions through smaller takeovers before astounding critics in 2000 by taking over a firm roughly its own size, its Swiss counterpart ZLB Bioplasma, at a time when McNamee was desperately sick and fighting testicular cancer. Four years later it followed that up by acquiring a second big target, US-based Aventis Behring. A third ambitious bid, for rival Talecris, was blocked by US regulators in 2009.

Many other Australian firms have made ambitious foreign purchases, only to come a cropper. McNamee says CSL succeeded because it was patient, disciplined and had worked out how the merged companies would fit together.

"Most acquisitions fail, in my view, because people overpay," he says. "We were very disciplined about what we bid and we had a very clear idea of how we would add value to it. You're always looking at things, but you have to be patient. You only buy a business when they're suffering; if they're not suffering, you overpay.

"You have to decide why you are the natural owner of that business. We never wanted to be a big company. We wanted to be a fine company that was very good at what it did."

CSL is now organised into a global supply chain, collecting and processing plasma and manufacturing a range of products. Its plants in Melbourne supply Australia, Asia and the Pacific. Its factory at Kankakee, near Chicago, produces plasma intermediaries for all CSL plants and supplies North America, and its plants in the Swiss capital Berne and Marburg in central Germany, supply Europe and the rest of the world.

Mergers were only part of McNamee's game plan. At the outset, he moved to lift productivity sharply by slashing CSL's staff. He made exports a prime goal. He cut out low-margin products, and - with some exceptions for the Australian market - narrowed CSL's product range to those where it could be globally competitive. And he was lucky that at Broadmeadows, the Hawke government was already building a global-scale plasma plant.

With Australian manufacturing now under so much pressure from the high dollar, those remain his core strategies. "You have to set your focus on world markets", he says. "We need to focus on being good at a smaller number of activities. We have to be in the premium products end.

"Switzerland and Germany have worked out how to deal with the problems of an overvalued currency, and that's primarily the problem we face. If the high dollar is here to stay, we need innovative industries and clusters. We're very fortunate to be in the Parkville area - the [research] networks it created have been very important for us."

One other thing McNamee firmly believes Australia must learn from Germany and Switzerland is the importance of wage restraint, to keep manufacturing globally competitive. CSL has just been through an unusually bruising wage negotiation in which its unions used strike action to win wage rises of 3.75 to 4 per cent over each of the next three years.

This was very different from the way its enterprise-based unions in CSL's Swiss and German plants operate. Germany entered the euro with an overvalued deutschmark, but won back its lost competitiveness with 15 years of wage restraint. Swiss workers have wage restraint ingrained in them. The OECD reports that in the 15 years since 1995, average wages have risen 22 per cent in Germany, 33 per cent in Switzerland - but 107 per cent in Australia.

So far, CSL has been able to cope with a dollar above parity, but McNamee warns that is no longer inevitable: "If you combine a high dollar with wages growth that sits ahead of the global competition, it's inevitable that will put many assets at risk - including CSL's."

But this time next year, that will be someone else's problem. Brian McNamee is not sure what he'll be doing, but at 55, he's got a lot of life in him.

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RBA warns on loan risks

INTEREST-ONLY housing loans, and loans for 100 per cent of the property's valuation, could be scrapped in future after the Reserve Bank's annual conference heard that they inflate property booms and busts.

Three papers from key economic institutions found requiring borrowers to finance part of the purchase themselves would help to moderate future housing booms - and reduce the scale of the subsequent bust.

Senior officials of the Reserve Bank, the International Monetary Fund and the Bank of International Settlements separately reported that setting maximum loan-to-valuation ratios could help reduce the damage housing cycles cause to the economy.

The Reserve Bank paper, co-authored by the head of its financial stability department, Luci Ellis, also found similar benefits from requiring borrowers to pay down the capital of the loan over time, rather than taking out interest-only loans.

Most Australian home loans already meet both criteria. But many housing investors take out interest-only loans for 100 per cent of the property's valuation, as do investors in commercial property.

Housing booms and busts, in the United States, Spain and Ireland, were the main cause of the global financial crisis. While Australia escaped relatively unscathed, the Reserve has used this year's conference to work out how the booms and busts could be better regulated in future.

Australia's banks are free to lend as they see fit. But the Australian Prudential Regulation Authority makes them set aside extra capital to cover loans for more than 80 per cent of a property's valuation. There are no bars to interest-only loans.

In a survey of housing policy options, senior IMF researcher Giovanni Dell'Ariccia found the most promising were setting limits on loan-to-value ratios, and borrowers' debt-to-income ratios.

"Containing leverage will reduce the risks associated with declines in house prices", he said. "This will likely result in fewer defaults when the bust comes ... (and) reduce the risk that a large sector of the real economy ends up with severe debt overhang."

The Reserve's paper, by Ms Ellis, Mariano Kulish and Stephanie Wallace, concludes that the terms of loan contracts "matter a great deal for financial stability... Loans that build in some amortisation of principal over time are less destabilising.

"Short-term loans that must be rolled over are particularly dangerous. This helps explain why commercial property lending ... has been so problematic for financial stability."

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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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What does the manufacturers' task force want? Lots

THE Gillard government now faces a host of tough budgetary and policy choices after its manufacturing task force urged it to cut business taxes, reduce "the impacts of the carbon price", and lift spending on infrastructure, skills and a range of other areas.

The task force, mostly of business and union leaders, warned that since 2008, the high dollar has cost 110,000 manufacturing jobs, 10 per cent of its workforce and 85,000 more are at risk.

With the dollar likely to stay high, the report said, the challenge is to create an economic environment and workplace culture that will make manufacturing more internationally competitive.

"This requires a business environment that supports continual innovation in products, processes and management," they said. But their 41 recommendations show this will not be cheap.

With manufacturing output 8 per cent below 2008 levels, they urge the government to bring forward infrastructure investment, buy more local content, create a housing recovery, and step up spending on small business and skills training.

The report proposes:

. A government-led effort to win Australian companies a bigger share of supply contracts for the $470 billion of mining-related investment in the pipeline, rather than see most of it go to imports.

. Bringing research institutes and industry together in "smarter Australia precincts", like Melbourne's Parkville medical precinct, so more of Australia's research expertise is directed towards making new products or improving them.

. Building on Australia's strengths by processing raw materials before export, especially processed food for Asia's markets.

. Developing more global niches in knowledge-intensive manufacturing, as Futuris has done in automotive interiors and CSL in plasma.

. Monitoring the impact of the carbon tax on emission-intensive industries, and ensuring it is "refined as needed" to keep firms globally competitive.

Prime Minister Julia Gillard said the government supports most of the report in principle, but shied away from committing to its spending proposals, saying they would be considered in the budget process.

She said the government's manufacturing support arms will combine to help Australian manufacturers bid for contracts in infrastructure and resource projects. It will also set up a "manufacturing leaders group" bringing employers, unions and government together.

"I want to make sure that we still have a strong manufacturing sector beyond the resources boom," she said. "Manufacturing provides us with a skill base, with innovation, and it provides working people with jobs."

Australian Industry Group CEO Innes Willox said Australian manufacturing needs to build on its strengths, improve its partnership with public sector research, become part of global supply chains and build a culture in which small manufacturers can grow big.

Mr Willox said manufacturing's biggest problem was the high dollar, quipping: "The dollar is number one, and it's about four games clear on top of the ladder." But industry must lift its productivity to become globally competitive even with a high dollar.

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Mining makes us 6th richest

THE resources boom has given Australia the sixth highest GDP per head in the Western world but most of that comes from temporary causes that will reverse, making high productivity growth imperative for our future, a new report warns.

Global consultants McKinsey points to the resources industry as the main culprit for Australia's poor productivity growth in recent years, saying it is wasting capital by overambitious planning and poor project control.

In a new perspective on Australia's productivity debate, a McKinsey report shifts the spotlight from labour productivity to capital productivity. It says the efficiency with which we use capital has fallen in recent years, putting a brake on growth at a time when mining investment has dominated the economy.

"Capital productivity in mining is the major issue", McKinsey partner Chris Bradley told The Age. "Australia's productivity challenge is to do the major projects better. We're not even halfway through this resources boom. The amount of investment ahead is bigger that what we've seen so far. We have the opportunity now to leverage the experience we've gained in this area to make the second half much better.

"Prices are not going to stay high, in all likelihood, and we're not the only resources player."

The report, Beyond the boom: Australia's productivity imperative, was written by a team headed by McKinsey senior public sector partner in Sydney, Charlie Taylor. It says Australia is one of the "fortunate few" rich countries with good income growth but its causes are transient, and productivity growth must drive the economy in future. The report estimates that most of Australia's income growth between 2005 and 2011 came from one-off factors: mostly rising export prices (the terms of trade) and the boom in capital inputs (mining investment).

While most of the fall in capital productivity had sound reasons the long gestation period of new mines, and miners digging up lower-value seams while prices are high it says capital productivity in new mines could be improved 30 per cent by better timing of projects, using simpler solutions, and making the design fit the budget rather than vice versa.

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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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Going down. Non-mining investment plummets

BUSINESS investment in the non-mining economy has shrunk to its lowest share of gross domestic product for almost 40 years, as a result of the high dollar and appears set to fall lower still.

The Bureau of Statistics estimates that in the nine months to March, business investment in manufacturing and services such as finance, retailing and IT fell to 4.95 per cent of GDP, its lowest level since 1972-73.

The bureau's quarterly survey, taken in April and May, found companies plan to invest even less in 2012-13. Manufacturers' investment plans were 11 per cent lower than at the same stage last year, while service companies' plans were down 4 per cent.

Even if these plans are upgraded as usual over the year ahead, the survey implied that non-mining business investment would shrink, to about 4.5 per cent of GDP.

That would take it back to levels last seen 60 years ago, in the savage bust that followed the Korean War boom.

The bureau figures were published weeks ago, but escaped attention, as analysts focused on the mining industry's record investment plans. At face value, two-thirds of all business investment in Australia this financial year will be in mining, and just a third in all other industries combined.

The Reserve Bank reported last week that in 2011, more than half of Australia's growth in GDP came from mining investment. Since the entire economy grew just 2.1 per cent, that implies growth in the rest of the economy was barely 1 per cent.

The Reserve voiced concern that the high dollar is doing more damage to the economy than it anticipated. While mining is booming, the Reserve reported that activity in the rest of the economy is subdued.

"In liaison, many firms indicate that they are slowing their investment spending in line with weaker cash flows, and are becoming more selective about which projects to pursue," it said. "Many companies [are] prepared to spend on machinery and equipment investment [only] to the extent necessary to offset depreciation."

The bureau figures show investment by non-mining companies has now slid well below its worst levels in the 1990-01 recession.

Non-mining investment between 1987 and 2000 averaged 6.6 per cent of GDP, as companies built new offices, hotels, retail complexes, or re-equipped factories, truck and car fleets or equipment hire centres.

But since 2010 it has ebbed as mining investment has boomed. Manufacturing investment, which averaged 3.4 per cent of Australia's GDP in the 1960s, has now slumped to less than 1 per cent, with much of that invested to process minerals before export.

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At last, our dollar worries the Reserve Bank

THE Reserve Bank's view of the year ahead foresees the economy growing at trend, against a background of grey clouds: a two-speed economy, with little growth in jobs, and a lot of downside risk from Europe, and the high dollar.

It sees the carbon tax having surprisingly little impact on underlying inflation: just 0.25 percentage points in 2012-13, then no more. It sees mining investment peaking in 2013-14, barely a year away, and detracting from growth thereafter.

If you think that's easily replaced, the Reserve points out that in 2011, even net of imports, mining investment made up most of the growth in our GDP.

The Reserve is troubled by Europe. It's on edge about the US, and the partisan impasse over the budget deficit. But it's relaxed about China, seeing its economy as having hit bottom and about to rebound as stimulus measures take effect.

Part of its concern about Europe is that it sees the investor exodus from European bonds ending up here, and pushing up the Australian dollar at a time when falling commodity prices should be driving it down.

What is new in yesterday's Statement of Monetary Policy is that for the first time, the Reserve accepts that a persistent high dollar could do more damage than it expected to businesses exposed to global prices which now includes much of the economy, as the internet spreads global competition to our service industries.

The Reserve does not canvass possible solutions, such as the Swiss policy of setting a cap on the exchange rate, and printing money to keep it there or in other ways, as advocated by its former board member Warwick McKibbin.

But it sees the high dollar forcing trade-exposed business to lift productivity sharply. That implies weakened jobs growth "in the near term" and a risk of "labour shedding across a range of industries", as the high dollar combines with the housing slump and deep spending cuts at federal and state levels.

It expects unemployment will "edge higher", wage growth will slow to 3.5 per cent, and inflation even with the carbon price to remain within its target band of 2 to 3 per cent.

Yesterday's statement does not imply an interest rate cut around the corner. But it implies that the Reserve is leaning that way. It sees the risks as mostly on the downside, but is sitting back to watch what unfolds, ready to hit the trigger if its fears are realised.

Commonwealth Bank's economics team summed it up as "cautiously optimistic". Yes, but it is more cautious than it was, and less optimistic than it was.

Some analysts interpreted the rise in its growth forecasts for 2012 as indicating stronger growth ahead. Wrong. It reflects stronger growth behind us, due to the Bureau of Statistics' surprisingly high first estimate of 1.3 per cent growth in the March quarter.

The Reserve assumes this will not be revised down much, but will lift the starting point for future growth. That could be optimistic. In the past, on average, high initial estimates of growth have been revised down by 0.4 percentage points. The bureau has already revised its estimate of March quarter retail spending by that much.

The key fact is that the Reserve has left its growth forecast to June 2013 unchanged: between 2.5 per cent and 3.5 per cent. And it has cut its forecast for growth in 2013-14 by half a percentage point, to the same range.

That is, the Reserve forecasts the growth rate over the next two years to be around 3 per cent, plus or minus half a percentage point. It describes this as "around trend". Good. There is a widespread but outdated assumption that our trend growth rate is 3.25 or 3.5 per cent; that was in the days of rising debt, and the Reserve believes those days are gone.

On Thursday, assistant governor Guy Debelle forecast that credit growth will remain subdued for years. He tipped it to grow "at the pace of nominal [GDP] 5, 6, 7 per cent most likely, for the next few years. I'm pretty sure we're not going back to double digit rates."

If he's right, that will have profound implications across the economy especially for growth in house prices, and for investments that depend on them rising at the pace we saw when housing credit was growing at double-digit rates: as it did, with two short breaks, from 1964 to 2008. Stable house prices will be good for first home buyers, bad for investors.

Second, slow growth in credit will have profound effects on banks, retailers, new housing and renovations, tourism, restaurants and discretionary expenditure of all kinds.

For all our talk of "cautious consumers", households have barely begun the task of deleveraging. The ratio of household debt to disposable income has shrunk only from 156 per cent at its peak to 150 per cent. It is still three times as high as it was 20 years ago.

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Carbon tax a mere hiccup, economically speaking

THE federal opposition's scare campaign against the carbon tax has failed its first test. The Bureau of Statistics reports that seasonally adjusted employment rose by 14,000 in July the month the tax took effect while unemployment fell to 5.2 per cent.

For the government, it was a double bonus after the TD Securities-Melbourne Institute monthly inflation gauge reported on Monday that inflation rose just 0.2 per cent in July, and was flat over the past three months.

While this was only the first test of the carbon tax, if the duo of rising employment and low inflation continues, it could have huge political implications undermining Opposition Leader Tony Abbott's repeated claim that the carbon tax would be "like a wrecking ball through our economy".

Mr Abbott yesterday stuck to his claim, pointing out that jobs rose only half as much in July as they had fallen in June. "Make no mistake, this is a python squeeze on our economy, and as time goes by it will squeeze families' cost of living, it will squeeze employment in this country," he said.

But Treasurer Wayne Swan was quick to claim vindication.

"It is yet more evidence that Tony Abbott's scare campaign on the carbon price and the mining tax is absolute baloney," he said. "Today's figures are the latest proof that he is deliberately misleading Australians and talking our economy down."

With the election not due for another year or more, the real test of the tax's impact on jobs and inflation lies ahead. But if the economy thrives over the coming year despite the tax as most forecasters expect it could become the political "game-changer" Labor is hoping for, discrediting the Coalition and its leader.

The bureau's preferred trend figures, however, paint a bleaker picture, which, if sustained, could give the debate to the Coalition. The trend data, which smooths out the ups and downs of monthly figures, estimates that job growth slowed to just 24,000 over the past three months, down from 42,000 over the previous three.

Forward indicators for employment are sending warning bells. The bureau's measure of job vacancies shrank by 15,000 in the 15 months to May.

Most of that decline was in Victoria, and mostly in white-collar jobs in professional offices, administration and healthcare.

Yesterday the SEEK index reported online job ads down 5 per cent last month and 11 per cent over the past year. The rival ANZ series was slightly less bleak, but it reported that job ads, online and in newspapers, shrank by 1800 last month and by 18,500, or 10 per cent, since February last year.

In trend terms, the bureau estimates that jobs have grown by 74,000 this year, or 10,000 a month. Only a third of the growth has been in full-time jobs. But the adult population is estimated to have grown by 136,000 in that time. Of the other 62,000, in net terms, the bureau estimates just 5000 more are unemployed, whereas 57,000 more have settled on the sidelines, not looking for work.

The jobs figures show Australia is still deeply divided between boom and bust, with Western Australia at one extreme, Tasmania at the other, and Victoria and NSW somewhere in the middle.

Western Australia is way out in front of any other state, adding 50,000 full-time jobs in the past year and cutting trend unemployment to 3.6 per cent. NSW takes the silver medal, but a long way behind, adding 20,000 full-time jobs in the year to July, with unemployment down to 5.1 per cent.

Victoria and Queensland were fighting out for the bronze. In Victoria, the bureau estimates, full-time jobs shrank by 23,000 in the year, but part-time jobs grew by 42,000. The state's unemployment rate was 5.4 per cent last month, down one notch from June.

Queensland, by contrast, added 4000 full-time jobs in the year while losing 10,000 part-time jobs. Its unemployment rate stayed at 5.6 per cent.

South Australia and Tasmania were clearly going backwards. On the bureau's figures, South Australia lost 18,000 full-time jobs in the past year one in 30 with unemployment up to 5.7 per cent. It now has fewer full-time jobs than it had before the GFC. Tasmania is in even worse trouble, losing 6800 full-time jobs in the past year, or more than one in 25.

Most forecasters still expect unemployment to edge up in coming months, if only slightly, with the Reserve Bank likely to deliver another interest rate cut this year.

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Fringe fading, inner-city Melbourne booming

MORE than 10 per cent of new homes approved in Victoria in the past year will be built in the city of Melbourne, as developers switch gears to meet the demand for inner city living.

The Bureau of Statistics reports that in the past two years, approvals for new homes on Melbourne's outer fringe have plunged by 25 per cent. Yet approvals in inner Melbourne have almost doubled, almost entirely in the CBD, Docklands and Southbank.

In 2011-12, for the second year in a row, most approvals for new homes in Greater Melbourne were granted in established suburbs within 20 kilometres of the GPO. Of 37,885 approvals in the metropolitan area, 8639 were in the inner ring, 20,374 were roughly within 20 kilometres of the GPO, and 17,511 on the outer fringes.

The figures undercut the state government's decision to take more land out of Melbourne's green wedges for housing. They suggest that increasingly, developers themselves are redeveloping the city and established suburbs to meet demand from buyers.

Last year, Melbourne City Council or the appeals body, the Victorian Civil and Administrative Tribunal approved 5166 new homes in the city, including 1915 in the CBD, 1712 in Southbank, and 640 in Docklands. That was more than the boom municipalities of Wyndham (south-west, 2835 new homes) and Casey (south-east, 2322) combined.

One in 28 homes approved in Australia was in the city of Melbourne. Of the $75 billion of building approvals nationwide, $4.5 billion or 6 per cent was on lord mayor Robert Doyle's turf.

There are fears that supply is rushing ahead of demand, with a risk that apartments could remain unsold, or drive down prices across the inner city, or never be built. Similar fears in 2003-04, however, proved unfounded.

The trend to live closer in is not confined to the CBD. Six other inner or middle suburban municipalities Port Phillip, Stonnington, Monash, Boroondara, Yarra and Moreland each approved more than 1000 new homes, mostly apartments and units.

Of the $7 billion of non-residential building approved in greater Melbourne, $3 billion was in the city centre. But Whitehorse council attracted $554 million of non-residential building, including the Box Hill hospital redevelopment.

On the outer fringes, buyers are going north. The biggest number of approvals last year was in Whittlesea shire, where 3260 homes were approved, mostly in booming suburbs such as South Morang and Mernda. The figures will add to pressure on the state government to extend the new South Morang rail line to Mernda.

Geelong is still booming, with 1897 new homes and $911 million of new building approved in 2011-12. Bendigo approved 1222 homes and Ballarat 985. Overall, metro Melbourne dominated, taking 79 per cent of the state's new homes and 81 per cent of the total value of approvals.

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