Henry's upside-down economics

Treasury secretary Ken Henry says very large fiscal packages have been designed by governments across the world, suggesting they "have learned something from history". That would be the governments that have taken the advice of their treasury departments, which totally failed to foresee the present debacle.

Henry reveals how the Treasury's modelling of the economy is largely uninformed by economic theory. Essentially, Treasury's model is a series of mechanistic forecasts about growth rates that are assumed to be inevitable, and simply delayed or accelerated as a result of world conditions. Last year Treasury pointed to an ageing of infrastructure in Australia, but such matters seem to have no bearing on future levels of growth and income.

Treasury's models naïvely add growth in employment and population and make an assumption about productivity. Thus, if Australia were to accept an extra half a million immigrants of mainly working age, this would, on Treasury modelling, bring an increase in gross domestic product of 2 per cent for population plus another 3 per cent for employment. Hey presto! We have just lifted growth by 5 per cent!

In reality, such a rise in immigration could have a negative effect on GDP, as hands and mouths create wealth only when combined with skills, infrastructure and capital investment.

Treasury's modelling can project broad aggregates a year ahead in a stable domestic and world economy, but it's hopeless at forecasting in times of rapid change. Thus, last year business investment was estimated to "remain flat" in 2009-10. Now it is forecast to fall 18 per cent.

This inability to predict investment drivers is the basic flaw in the Treasury models' medium and long-term forecasts. Contrary to Henry's view, growth is not some preordained upward trajectory that might be interrupted, but subsequently simply catches up on its trend. Still less is it a revenue stream that can be raided without undermining its fecundity.

Economic growth depends upon government resisting its natural inclination to tax and spend. Its basis is accumulating savings and ensuring that nothing impedes these savings being allocated to productive investment. That's why economic growth took off in the industrial revolution leading to the modern era. It's why Japan embarked on an explosive industrialisation in the 1950s and 1960s, increasing its per capita income levels from a quarter of Australia's levels to surpass those of this country. It's the reason Hong Kong, Singapore, Taiwan and Korea followed suit in the 1970s and 1980s, and why China and then India have embarked on the same path.

Spendthrift countries have failed to grow, although some, like many in Africa, started off better placed than many of the success stories.

Henry fails to understand this and offers growth prescriptions that are the opposite of what is needed, as revealed in his defence of the various Rudd spendathons when he argues that employment would be much lower if there had been no government spending. But the spendathons' injection of funds into the economy came from savings. The government cannibalised savings and delivered them to parties with a high propensity to consume.

This policy of borrowing from the future for consumption now is the opposite of what is needed to create sustainable growth and jobs. It diminishes the capability of the economy to sustain growth because the future has been raided - funds that would go to investment have been siphoned off into consumption.

Henry's picture of the economy not only leads him into a cavalier approach to the nexus of investment and income levels, it also leaves him indifferent to measures that will reduce the economy's income-generating capacity. He overlays what he calls a vast reform agenda onto the income-diminishing measures that have been budgeted. This agenda includes a carbon tax designed to raise the price of energy and to thus reduce the competitiveness of our most efficient industries. This blow on top of all the other damage is shrugged off as just another perturbation to be managed out of the cornucopia that is seen to be the natural state of the economy.

Without a reversal of the present policy approach, the best Australia can hope for is a long period of economic stagnation.