Economics
Where to now for monetary policy?
The Reserve Bank is confused because their models cannot deal with shocks and structural change.
The Reserve Bank’s Statement on Monetary Policy explains the reasoning that led it to keep interest rates on hold. It reads like an explanation of the way a rabbit freezes in front of a car’s headlights, unable to decide which side of the road to head for.
Its confusion stems from economic indicators which suggested that inflation and unemployment were both rising: that’s not supposed to happen. The economy was disobeying the basic equation underlying macroeconomics, the “Phillips Curve” that models an inverse relationship between inflation and unemployment.
On The Economy Stupid Peter Martin discusses the Reserve Bank’s behaviour with Michael Pascoe of Michael West Media and Nicki Hutley, now of the Climate Council. The title of the session is But what if the AI bubble doesn’t burst? They get on to the AI bubble later, but the first 20 minutes of discussion is about the way the RBA is dealing with what it sees as contradictory data – that is, by doing nothing.
The RBA’s faith in its fundamental model is further undermined by the IMF’s publication of a document – Navigating the 2022 inflation surge – revealing that countries like Australia that used strong or mandated inflation-targeting policies to beat post-pandemic inflation did no better at beating inflation than those that did not use such policies. In fact by some indicators the countries that used less aggressive policies did better.
The reason for this outcome, the IMF economists believe, is that the post-pandemic inflation resulted mainly from global supply-side shocks, rather than from demand-supply imbalances, which underlie the basic macro models.
Those demand-supply models apply in situations where there is a circular (and possibly accelerating) loop of higher wages, leading to higher prices, leading to higher wages, and so on, worsened by loose monetary and fiscal policy applied by governments trying to boost demand. For extreme examples think about the Weimar Republic, Zimbabwe, and Venezuela. Those loops have to be cut before they become out of control.
But at other times much of what shows up in indicators of “inflation” is a once-off adjustment in prices, associated with economic shocks or structural change. The world experienced that in the 1970s when the Bretton Woods order of fixed exchange rates collapsed exposing the lack of competitiveness of industries in “developed” countries. At the same time the price of oil leapt from its hitherto stable $US3 a barrel to double or triple that price, in a market subject to unpredictable bouts of cartelization and competition. In that time many countries, including Australia, experienced “stagflation” – periods of rising unemployment and worsening indicators of inflation.
Although their causes are different, the global disruptions of our time are similar in many ways. This time they have to do with the disruption of a pandemic and its aftermath, an unpredictable and economically illiterate narcissist dictating the economic policies of the world’s (still) largest economy, the disruptions of wars, and the rapid and unpredictable uptake of artificial intelligence. In Australia we have the added stresses resulting from a massive and urgent energy transition, and from climate-change induced shocks to our food production systems.
These disruptions show up in indicators such as the CPI, which, we should remember, is an indicator of the changing financial cost faced by households regularly buying the same basket of goods and services. The RBA can defend use of the CPI as an indicator of inflation in times when the economy is structurally stable: at such times all that’s happening is a mathematically linked set of nominal price and wage movements. That’s textbook “inflation”. But in times of shock and rapid structural adjustment it’s difficult to make meaning of figures that pop up in inflation indicators – figures that almost always result from nominal price rises because that’s the dynamic of capitalism which sees short-term profits before competition brings down prices over time.
This broad context of monetary policy is captured in a post by the ABC’s Ian Verrender: Why Michele Bullock is relieved she is keeping rates on hold as markets continue to shift. He addresses the structural shocks described above. But he also warns about the rapid growth in asset prices, particularly shares in artificial intelligence ventures that are yet to return any profit. He sums up the fears of cool-headed economists, and the prevailing exuberance of those who claim that this time is different from previous booms and crashes, in his words:
It's always different. Until it isn’t.
The slow track to high-speed rail
Another announcement accompanied by modelling built by people who have been blocking HSR for 40 years.
When did you first hear about proposals for high-speed rail in Australia? If you are 70 or older you may remember the 1984 CSIRO proposal for a Sydney-Canberra-Melbourne line, based on France’s TGV, which was one of the earliest serious proposals. Subsequently there have been several proposals, all rejected by government economists, who know that if you apply a few tough assumptions about cost and patronage, and a high enough discount rate, you can kill any good investment proposal.
We read in the media about a breakthrough however.
Does this mean that funds have been appropriated, that surveyors are out there developing a route, that the High Speed Rail Authority is negotiating with landholders and consulting with communities along the Brisbane-Adelaide corridor?
No – it’s about another piece of paperwork, the Infrastructure Australia’s Business Case Evaluation Reportrelating to a high-speed rail connection between Newcastle and Sydney. Writing in The Conversation last year – High-speed rail plans may finally end Australia’s 40-year wait to get on board – Phillip Laird of the University of Wollongong described how this proposal arose as the High Speed Rail Authority’s first section of an east coast line from Brisbane to Melbourne.
It may have a slightly longer shelf-life than other proposals, because it comes from Infrastructure Australia, which is one of the harder bodies to convince on the value of public investment. (Don’t be misled by its name.)
But it doesn’t really promote the case for a Newcastle-Sydney line: rather it is slightly less negative than other reports. It uses data from the High Speed Rail Authority’s assumptions but it reworks those figures, using more conservative assumptions about benefits, and using a high real discount rate (7 percent), to return a benefit-cost ratio of a miserable 0.1.
It assumes that construction would start in 2027, be partly completed in 2037, and fully completed in 2042. That means it would be 15 years before the project’s full benefits are realized. Modelling that assumes a long construction time is a surefire way to kill a project proposal, because every year’s delay means another year before benefits are realized, which reduces the project’s net present value and therefore the project’s benefit-cost ratio. A dollar of benefits in 15 years’ time has a present value of only 36 cents at a 7 percent discount rate.
For details of this Newcastle-Sydney proposal, on the ABC’s Saturday Extra you can hear Buddhima Indraratna of the University of Technology, Sydney discussing the Infrastructure Australia evaluation with Nick Bryant.
Indraratna, who describes himself as a high-speed rail tragic, points out that geography and established settlement patterns along the 194 km route require more than half of it (115 km) to be in tunnels.
It’s a strange choice for an initial project. A cynic could suggest that they have chosen this segment because it is the most expensive, as a way to demonstrate to the public that high-speed rail is uneconomic. Bryant asks Indraratna why other, flatter, routes, such as Sydney-Melbourne, don’t have priority (and Infrastructure Australia does not even mention the easy Melbourne-Adelaide route). Laird’s Conversation article, linked above, draws attention to groups who have advocated other projects, involving passengers and freight, on the busy Sydney-Melbourne route, presently served by a slow steam-age line that is 60 km longer than a modern line would be. The ability of a high-speed line to carry freight would certainly boost its economic justification.
Once were nation builders
Indraratna suggests that Australia has less need for high-speed rail than other countries, because we have well-established airline services between our big cities, because we have high car ownership, and because we don’t have the high populations of countries like China and Japan.
Many would respectfully disagree with his assessment of our airlines. In European countries with proper rail services short-haul air travel over distances such as Sydney-Melbourne are no longer people’s first choice as a mode of travel. That’s because every aspect of air travel, except for the departure-runway to destination-runway, has become slower and slower, and less and less reliable. And the worst emissions per km of travel are from short-haul flights: it takes a lot of fuel to lift 80 tonnes of airplane to 10 000 meters.
Australia, with 20 million people in concentrated urban areas along a single route between Brisbane and Adelaide, and with a very old rail system hardly serving its purpose, should be very well set up for high-speed rail, following the example of European countries. Even significantly poorer European countries, such as the UK, Spain and Italy, have thousands of kilometres of high-speed rail and have more under construction.
What’s holding us up does not seem to be the economics of high-speed rail, but a culture of national meanness when it comes to transport infrastructure. It’s the culture that rations infrastructure spending through use of discount rates set way above the government’s cost of borrowing, based on the ideology that public sector investment has to be curtailed because for some unexplained reason public investment “crowds out” rather than complements private sector investment.
It's also the consequence of a “we can’t do It here” mentality among policymakers, which is in stark contrast to the periods when our prosperity was driven by a nation-building attitude, when the engineer had more respect than the financier, and when we realized that our prosperity rested on both the public and private sectors.
Solar share – clever politics, mostly sound economics
Providing three hours of free electricity is clever politics and should result in more efficient resource allocation.
Add batteries and we can do away with those “retailers”
Three hours of free electricity!
Where’s the catch in the government’s Solar Share scheme which will require retailers to offer three hours of free electricity sometime around the middle of the day, when solar generation is at its peak?
There are a few conditions, but because it manages to combine clever politics with sound economics, it passes the basic criteria for good public policy.
To start with the politics, it carries the message that renewable energy is plentiful and low-cost – so cheap that it can be given away.
OK – engineers, economists and policy wonks know it’s more complicated than that, but (fortunately) most Australians aren’t engineers, economists or policy wonks. They’re people who have been subject to a torrent of lies about the drivers of electricity prices.
Its timing is clever, coming at a time when the Liberal Party is tearing itself to pieces in response to the idiocy of its now senior coalition partner who have committed themselves to an economically and politically destructive policy on climate change. Giles Parkinson, writing in Renew Economy, reports on the path the Coalition has taken itself down: Free solar, nuclear cost blowouts, and “deadly negligence” on climate: A heady mix for the Coalition.
Solar Share puts retailers and owners of networks on the spot. These businesses have been raising their prices, while with help from the Coalition and the Murdoch media they have been blaming renewable energy. Solar Share should expose their deceit because the easy, and largely correct common interpretation of the free electricity provision, is that if electricity is so cheap to generate from renewable resources, the ripoff must be occurring down the line.
The economics of Solar Share are simple. If electricity is plentiful in the middle of the day – so plentiful that prices become negative and some generators have to switch off as prices become negative – and scarce in the early evenings, it makes sense for consumers to shift the time they use it, but they may need a nudge to do so.
The ABC’s Daniel Mercer and Alex Lim describe the daily supply cycle, including the role played by different energy sources at different times: We have more renewable energy than ever before. Why are we switching it off?
Some commentators point to the scheme’s shortcomings. One is the suggestion that retailers will respond by bumping up early evening prices to compensate for their loss of daytime revenue. Another is that it will be taken up only by the well-off and those who are at home all day.
On the former Finn Peacock of Origin Energy voices his misgivings about Solar Saver on the ABC’s The Business program. The latter point is in a Renew Economy article describing the scheme by Sophie Vorrath. Bruce Mountain of the Victorian Energy Policy Centre has a Conversation contribution: Three hours of free power sounds great – but it could raise other costs and hamstring rooftop solar.
The main reason for shifting demand is that the electricity we use in the evening peak is expensive, really expensive. That’s when more gas has to be added to the supply mix. It’s to provide that boost that old coal-fired stations are kept on life support. If peak use can be reduced, even if it is shifted to other periods, there should be a net cost saving across the system. If retailers raise their evening prices, that may provide another nudge for consumers to shift their time of use.
It Is true that some will be in a better position to shift demand than others. Those who are at home during the day – retirees, shift-workers, people working from home – will be in the best position. Some of the scheme’s enthusiasts suggest that people schedule their dishwashing and laundry to free electricity periods, and use those delayed timing settings on ovens (in case you threw out the instructions you’ll find them on the Internet), but these are not the heavy lifters. The people most likely to benefit are those with batteries and electric cars (batteries on wheels).
They are all valid points – not everybody can shift their demand – but the main economic purpose of the scheme is to bring down the total cost of providing electricity and to reduce emissions from coal and gas. Some will miss out, and some will benefit, but if the scheme is effective in reducing peak demand, even those who can’t shift their time of use should benefit. There are other ways to address bigger equity issues in electricity prices.
In fact it is possible that making electricity free will work better than the government expects, because free services have a particular attraction. Behavioural economists note that big price reductions do result in higher sales: those beloved demand curves have some validity. But that response (“price elasticity” in the language of economists) is minor compared with the jump in consumption when something becomes free, particularly if it is free for a limited time. In the case of electricity few people know the hourly cost of running their appliances (a major market failure in itself), but they do know that if electricity is free they don’t have to worry about their use at all.
Bruce Mountain makes the point that providing free electricity will reduce the attraction of installing rooftop solar. But perhaps we have enough rooftop solar for now: that is one of the reasons there are periods of negative prices necessitating curtailment of supply. Solar Share should cause people seeking to bring down their power bills to think of investing in batteries before they invest further in rooftop solar.
One feature of Solar Share is that it will be available only to those whose electricity contracts are on the “Default Market Offer”, which is essentially the most costly plan that retailers are permitted to offer. That means it may discourage people from shopping around for cheaper plans. But as has often been pointed out in these roundups, shopping around brings no net consumer benefits: it’s a redistribution of costs among consumers, with the added burden of search and transaction costs.
Much depends on the specific response of retailers. Tristan Edis of Green Energy Markets writing in Renew Economy – Free electricity in the middle of the day is not free of risks – warns that retailers may respond by increasing the daily fixed charge for electricity supply. If people are generating and storing their own electricity that cuts out the retailers. In substituting fixed charges for charges based on kWh usage, such a move would dull price signals in the electricity market, and would relatively penalize those whose use is small. That would be bad economics, but it would be good for the retailers’ cash flow and profits.
The possibility that retailers will respond to Solar Share in ways that disadvantage consumers and that distort resource allocation is another reason the Commonwealth, or state governments in cooperation, should renationalize the electricity distribution system, recognize that “retailers” are an expensive and unnecessary overhead, and use a non-profit entity with a public interest charter to mediate prices between generators and consumers.
Migration myths
Migrants aren’t to blame for expensive houses or stress on infrastructure: in fact they’re making more contribution to our shared assets than native Australians.
Many Australians believe that migrants are responsible for pushing up house prices and that they are putting undue stress on our public infrastructure.
The ABC’s Tom Crowley brings data to bear in dispelling those beliefs, in a post These charts show the effect of migration on Australia’s housing story.
On housing he points to research showing migrants have indeed contributed to rising house prices, but only by a small amount. Over the 10 years between 2006 and 2016 nominal house prices were rising at 6 percent a year, but only 1 percent of that 6 percent was attributable to migration. He also points out that migrants not only buy houses; some, attracted by our preference for skilled migrants, build houses.
As for demand for schools, health care and infrastructure – services that are generally funded through public expenditure – Crowley draws on Treasury modelling demonstrating that migrants contribute to public revenue.
That modelling shows that over their lifetime Australians on average enjoy $620 000 of benefits drawn from the public purse, while they contribute only $535 000 as taxes – a shortfall of $85 000. Migrants, however, are net contributors to public revenue. The graph below, a reconstruction of a similar graph in Crowley’s post, shows that employer-sponsored migrants make a significant contribution to public revenue (taxes of $1 million, withdrawals of $0.5 million) and that their partners make a small net contribution.
Do those people demonstrating against migration realize that they are demonstrating in support of higher taxes?
Choice
Providing consumers with choice is one means of delivering benefits to consumers, but when choice becomes an end in itself it is often detrimental to consumers.
Isn’t it wonderful that we have an economic system with so much choice? Think of the array of cheeses in a delicatessen. Think of the number of car makes on the market, all offering a variety of basic models, with different drive trains, tyre profiles, entertainment systems, trim, and colour. Think of the hours you could spend comparing electricity plans to make the best choice for the next few months.
The expansion of choice in societies like ours has surely been yielding diminishing returns, and may even by yielding negative returns, but we’re not supposed to think that way, because it’s heretical.
In Saturday Extra last week Nick Bryant interviewed Sophia Rosenfeld, posing the question Does choice give us more freedom?.
Rosenfeld explains that the exercise of individual choice, not only in markets but also in other realms of life, is a relatively modern phenomenon, having started and slowly expanded from the time of the Enlightenment. The enlightened society is populated by decision-makers making choices guided by their own reasoning, not by the dictates of the state or some paternalistic guardian.
For a long time there has been the idea of moral choice, allowing us to make the right or wrong decision according to some religious or embedded moral code. But it’s the idea of choice relating to personal preferences that’s comparatively new. My decision whether or not to evade taxation is a moral choice, in a way that my decision to buy Adelaide Hills brie rather than Milawa brie isn’t.
Almost in passing Rosenfeld mentions the emergence of the right of citizens to choose their representatives. She overlooks the situation in her own country, the USA, which can offer 40 320 varieties of hamburger (factorial 8), but only a binary choice at the ballot box, constrained by their single-round first-past-the-post system. Political choice threatens the rich and powerful in ways that market choice doesn’t.
She acknowledges that in some markets we can become overwhelmed with choice. That’s putting it mildly: Joshua Gans coined the term Confusopoly to describe the use of excess choice as a seller’s means of weakening buyers’ market power, negating the basic and untested assumption among economists that more choice is always of benefit to consumers. (If economists didn’t hold that assumption as a matter of faith they wouldn’t be able to draw those lovely indifference curves.)
Economists can point to the benefits of choice: it is the mechanism by which markets bring us lower prices and innovation. But it also has its costs. On the consumer side it involves search costs as Gans points out: add up the hours you may have sat at your computer comparing products or services. And it involves costs on the supply side including promotion costs, and in many industries the cost of duplicated and underused capacity. Think of the way Australia’s attempt to sustain too many car manufacturers resulted in all of them going out of business.
One assumption in the economists’ market model is that consumers are always able to make well-informed decisions in their market choices. That’s not a bad assumption for cheese, but for products like health insurance it’s virtually impossible for the consumer to compare the products on offer, because we don’t know our needs, and health care is a confusing area for even the well-educated. But bludgeoned by the Medicare Levy Surcharge, Australians are forced to “choose” between look-alike health insurers whose advertising and administrative costs are bloated by the need to compete with one another. Similarly in electricity distribution we have to choose between “retailers”. Unlike two competing shops that offer exactly the same Adelaide Hills Brie, these “retailers” offer exactly the same product from a single supplier. They are no more than commission agents.
Private health insurance and electricity are examples where the ideology of “small government” has driven privatization, without regard for consumer interests.
As a general rule in markets where real choice is necessarily limited, particularly utilities such as water supply and electricity, and when the technologies are mature, there is little scope for product or process innovation. The consumer has to take what’s on offer. That’s why efficiently operated publicly-owned utilities pretty well always do a better job at serving consumer interests than competing private companies.
Rosenfeld is author of The age of choice: a history of freedom in public life.