Gittins' Guide to Economics

GITTINS’ GUIDE TO

ECONOMICS

GITTINS’ GUIDE TO

ECONOMICS

ROSS GITTINS

First published in 2006

Copyright © Ross Gittins 2006

All rights reserved. No part of this book may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording or by any information storage and retrieval system, without prior permission in writing from the publisher. The Australian Copyright Act 1968 (the Act) allows a maximum of one chapter or 10 per cent of this book, whichever is the greater, to be photocopied by any educational institution for its educational purposes provided that the educational institution (or body that administers it) has given a remuneration notice to Copyright Agency Limited (CAL) under the Act.

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Cataloguing-in-Publication entry:

Gittins, Ross.

    Gittins’ guide to economics.

    Includes index.

    ISBN 1 74114 799 9.

    1. Economics. I. Title.

330

Set in 11 on 14 pt Adobe Garamond by Midland Typesetters, Australia Printed by McPherson’s Printing Group

10 9 8 7 6 5 4 3 2 1

CONTENTS

Preface

Abbreviations

Part I Introduction to economics

1 Money isn’t what it’s all about

2 How the economy works

3 It all gets down to scarcity

4 Economists’ obsession with prices

Part II The labour market

5 How the labour market works

6 Reform of the labour market

7 The labour market’s changing future

Part III The financial markets

8 How interest rates affect demand and inflation

9 How the Reserve Bank influences interest rates

10 Real interest rates and expected inflation

11 The dollar goes up as well as down

Part IV Government and the economy

12 Market failure and government failure

Part V The global economy

13 How globalisation is helping poor countries

14 The pros and cons of financial globalisation

15 The World Trade Organisation’s Doha round

16 Transnational corporations’ size is exaggerated

17 The rise of China

Part VI Australia’s place in the global economy

18 Composition and direction of our exports

19 Australia’s growing investment abroad

20 Why industry protection doesn’t work

21 How globalisation affects our economy

Part VII Economic issues

22 The coming slowdown in economic growth

23 Good news and bad on unemployment

24 How we tamed inflation

25 Why we worry less about the current account deficit

26 The distribution of income

27 Management of the environment

Part VIII Economic policies and management

28 Shocks to the economy

29 Macro management and the business cycle

30 The changed policy mix

31 Fiscal policy versus monetary policy

32 A different perspective on monetary policy

33 Microeconomic reform and productivity improvement

PREFACE

This book is intended for students of economics of all ages, but particularly those at senior secondary and tertiary levels. It’s not a textbook, however. Rather, its role is complementary, bridging the gap between theoretical and rapidly dating texts, and the ever-changing world of economics as applied to the Australian economy. I trust it’s also more accessible and readable than a text. It could serve as a primer to those whose days of formal education are behind them, but who have discovered a need to get up to speed on matters economic.

Versions of most of the chapters in the book have been published previously as articles in The Sydney Morning Herald and The Age, particularly in my column in the business section on Saturdays. A few chapters have been drawn from speeches I’ve given, and some have been specially written for the book. All have been revised and updated to incorporate recent developments and the latest statistics.

Thanks to my boss, Robert Whitehead, and to Chris Caton and Tracey McNaughton of BT Financial Group, and especially to Kieran Davies of ABN Amro for help with graphs.

Ross Gittins

Sydney, August 2005

ABBREVIATIONS

ABS Australian Bureau of Statistics

ASEAN Association of South-East Asian Nations

AWA Australian Workplace Agreement

CAD Current Account Deficit

CEO Chief Executive Officer

CGS Commonwealth Government Securities

DFAT Department of Foreign Affairs and Trade

ERA Effective Rate of Assistance

FDI Foreign Direct Investment

GATT General Agreement on Tariffs and Trade

GDP Gross Domestic Product

GNE Gross National Expenditure

GST Goods and Services Tax

IMF International Monetary Fund

IRC Industrial Relations Commission

ICT Information and Communications Technology

LPG Liquid Petroleum Gas

MFP Multi-Factor Productivity

NAIRU Non-Accelerating-Inflation Rate of Unemployment

OECD Organisation for Economic Co-operation and Development

OPEC Organisation of Petroleum Exporting Countries

PC Productivity Commission

PPP Purchasing Power Parity

RBA Reserve Bank of Australia

TCF Textiles, Clothing and Footwear

TRIPS Trade-Related Aspects of Intellectual Property

TWI Trade-Weighted Index

WTO World Trade Organisation

part I

INTRODUCTION

TO ECONOMICS

chapter 1

MONEY ISN’T WHAT

IT’S ALL ABOUT

Joan Robinson, distinguished Cambridge economist and contemporary of Keynes, once said that the purpose of studying economics is to learn how to avoid being deceived by economists. My take on the subject isn’t quite so defamatory; I think we study economics to learn when to use the many synonyms for the word ‘money’. Economics is full of them: income, wealth, assets, liabilities, debts, wages, costs, prices, revenue, savings, investment, and more.

I was reminded of this notion by an email query from a reader. ‘Could you explain how the new wealth is being created year after year on a national and international level?’ he wrote. ‘How do governments and central banks decide how much money to print to replace existing notes and also to cover newly created goods and services? As I understand it, the amount of money flowing around is growing all the time—and it’s not just because of inflation.’

To the person who’s innocent of the study of economics, economics is ‘all about money’. To the person who’s learnt the least bit of economics, however, money is only a small part of economics, and by no means the most important part. We could run the economy without money, at a pinch—though it does work much better with it than without it.

What we couldn’t do without is resources: land (including minerals in the ground and plantations), physical capital (machinery of all kinds, buildings of all kinds, roads, bridges, and other social and economic infrastructure) and labour of all kinds (ranging from builders’ labourers to CEOs and prime ministers). And these days we have to add to those classical resources the ‘environmental assets’ the early economists weren’t really conscious of: air, water, fish in the sea, flora and fauna, and the ecosystem generally.

The point is that ‘the economy’ consists of us taking those resources every day and using them to produce a whole host of goods and services, which we promptly consume. That’s what economics is about: studying the processes involved in humanity’s endless round of production and consumption. So, how is new wealth created year after year? That’s how. Not by governments printing money, but by most of us getting up every morning and combining our labour with materials and capital equipment to produce a bunch of goods and services.

We each specialise in the production of a particular type of good or service. We then exchange the stuff we’ve produced for the stuff other people have produced so that we each acquire the particular bundle of goods and services we (and our dependants) wish to consume. We could conduct this process of exchanging goods and services without the use of money—that is, by means of barter— but we find it much more convenient to use an invention called money as a ‘medium of exchange’.

See the point? The wealth of a particular society—the United States, say, or South Korea—is determined not by how much money it prints, but by the value of all the goods and services it produces in a period (which is, of course, its ‘gross domestic product’). The thing to understand is that money has no intrinsic value. Its value is derived from its ability to command real resources—that is, from the quantity and quality of goods and services it enables you to buy.

Consider an economy that produced no more goods and services this year than it did last year, but which doubled the amount of money in circulation. Would that make its citizens twice as wealthy? Hardly. What you’d have is a classic case of inflation—‘too much money chasing too few goods’. You’d expect wages and prices to double and the purchasing power of a dollar to halve, leaving everybody no better or worse off than they were. (In practice it may be more complicated than that, particularly if there’s a lot of idle labour and production capacity at the time, but that’s a topic for another day.) Moral: it’s the amount of production that matters, not the amount of money in circulation. Money’s role is mainly to grease the wheels of production, exchange and consumption.

At the level of a particular society, economists use the term ‘wealth’ in two conflicting ways. They’ll say—as I’ve just done— that a nation’s wealth is the value of all the goods and services it produces in a period. Strictly, this is the nation’s ‘income’ and is measured by its GDP. But rather than measuring wealth as the annual flow of income, you can measure it as the value of the stock of physical resources the society owns: its farms, mineral reserves, factories and other businesses, housing, etc.—less the part of those assets owned by foreigners and the debts owed to foreigners. That’s the stricter meaning of the nation’s wealth. And you can do the same thing at the level of the individual worker or household: look at their income over a period or at their net wealth—assets minus liabilities at a point in time.

All these amounts we’ll measure in monetary terms, but they won’t be money. Your home, for instance, is a physical asset—it’s not money, though you could turn it into money by selling it. So, regardless of what’s happening to its money, a society increases its ‘wealth’ (its income) by producing more goods and services than it did last year. How? The obvious way is by employing more workers for more hours and by investing in more machines and other physical capital. The less obvious (but far more important) way a society increases its production is by improving its technology so as to raise its productivity (its output per unit of input). It does this by inventing better machines and generally finding more efficient ways to combine labour and physical capital.

OK. If I’ve convinced you that, despite its obvious usefulness, money isn’t really what the economy’s about, let’s take a closer look at the stuff. The first thing to note is that notes and coins constitute only a fraction of the nation’s money. Money held in bank accounts and the like outnumbers the value of notes and coins by about 20 to one. So how does the central bank decide how many notes to print? That’s easy—it sells the banks all the new notes they want to buy. The amount of currency on issue is, in the jargon, ‘demand determined’.

It’s true that the ‘money supply’—being notes and coins plus money in bank and building society accounts—is growing all the time, and by more than just the rate of inflation. But note this: in 2003/04, our economy produced goods and services worth a total of $814 billion. But the amount of ‘broad money’ in circulation that year averaged only $629 billion. So broad money had to turn over 1.3 times to accommodate that year’s production. What does that prove? Nothing much. Money is the shadow, not the substance.

chapter 2

HOW THE ECONOMY

WORKS

There’s nothing like speaking to a talkback jock to get an economist’s feet back on the ground. ‘We can’t get rich buying and selling to each other,’ one of them said to me the other day. I was taken aback. ‘Of course we can!’ I said, a little too abruptly. We can, and we do. ‘Buying and selling to each other’ is exactly the way the great majority of working Australians make their crust. And over the years it’s made us quite rich by the standards of most nations.

I’m not quite sure what it is that’s left so many people with the notion that there’s something futile, something unproductive— something incestuous, almost—about buying and selling to each other. I guess it’s the idea that, as a nation, we make our living by selling things to people in other countries—by producing exports, in other words. This is a view that’s strongly held by country people, who see themselves as the people who’re keeping the economy afloat. They produce the bulk of the