Check against delivery
In my comments to you today, I shall reflect on my two stints at Treasury: the twenty years I spent in the department up to 1993 and the three-and-a-half years I’ve been here since my return.
Macroeconomic policy then and now
Before talking about our approach to macroeconomic policy during my first period at Treasury, let me sketch very briefly the economic background of that time.
The 1970s and 1980s were marked by confronting economic volatility. Australia and other developed economies were hit by severe recessions, with the unemployment rate rising sharply and reaching post-Great Depression highs. Inflation re-emerged as a serious macroeconomic phenomenon for the first time in decades and, in most economies, became entrenched and we experienced “stagflation” – something that the post‑war Keynesian orthodoxy could not explain.
While external circumstances – including two oil price shocks and the breakdown of the post-World War II exchange rate order – were proximate causes of this instability, Australia’s problems were also home-grown.
Long-standing flaws in our domestic economic structure were exposed. Over many years protectionist policies had hardwired inefficiency into our economy, leaving us with little scope to weather shocks and complicating the task of macroeconomic policy.
This period was not a good one for either economists or economic policymakers.
This economic and intellectual turbulence posed serious difficulties for macroeconomic policy. By and large, the Keynesian optimism that policy fine‑tuning could banish the cycle diminished. Indeed, far from being a stabilising force during this period, policy often had the opposite effect. The two years of concerted fiscal stimulus under the Whitlam Government is a case in point.
Policy settings were subject to unexpected change, with a lack of clarity at times about underlying goals. For much of the 1980s, for example, a preoccupation with the short-term current account deficit crowded out traditional policy concerns.
In the 1970s and 1980s, in particular, fiscal policy followed a somewhat stop-start pattern: periods of rapid acceleration followed by hard braking. Monetary policy authorities adopted, only to later abandon, a strategy of targeting monetary aggregates. And there was a – now forgotten – preoccupation with velocity.
One example sticks in my mind. In May 1989, Paul Keating issued a statement on the March quarter national accounts. He referred to recent steps the Reserve Bank had taken to tighten monetary policy, stating that interest rates would have to remain high until ‘clear evidence’ emerged that the current account deficit was ‘trending down’.
In November 1990 when I was with then-Treasury Secretary Chris Higgins at a Heads of Treasuries Meeting in Adelaide, the September quarter CPI result came out at 0.7 per cent: far below the 1.7 per cent or so we had expected. With this surprising and welcome drop in inflation, the monetary policy narrative quickly and sensibly changed. In place of the current account deficit, inflation reduction became the more prominent justification for the tighter policy.
During the subsequent early 1990s recession which saw the unemployment rate rise sharply to exceed 10 per cent, the Government prudently maintained its firm fiscal policy line. By the beginning of 1992, more than a little unexpectedly, the economy had started to recover. While fiscal policy was loosened in early 1992, its economic effects were not felt for some time until the recovery was well underway.
The policy record was not uniformly poor – far from it. The economic circumstances policymakers faced were extraordinarily difficult and the political situation was fluid to say the least. On both the fiscal and monetary policy fronts, some important achievements were chalked up. And, at this time, attention was finally given to our long-neglected microeconomic policy challenges.
By the time I left Treasury in 1993, the early shoots of a more medium-term approach to macroeconomic policy were starting to show. At this time the then-Treasurer John Dawkins commissioned a report into national savings overseen by Vince FitzGerald and primarily authored by Karen Chester and other Treasury officers. That report emphasised the value of seeking to maintain a Commonwealth budget surplus over the course of the cycle.
In 1993, the Reserve Bank adopted an inflation targeting objective. This would be pursued over the economic cycle, giving policymakers a degree of discretion. In 1996, the newly-elected Howard Government explicitly recognised the independence of the Bank and formally endorsed the inflation target.
Parallel changes were made to our fiscal policy framework. In 1996 and now ensconced in the private sector, I was a member of the Audit Committee that the Howard Government established under Bob Officer which, among other things, developed the Charter of Budget Honesty. This Charter was legislated by the Howard Government. It gave fiscal policy an explicit medium-term focus, requiring budget balance to be maintained on average over the course of the economic cycle.
In early 2015, when I returned to Treasury after 14 years in London, the medium-term focus of both fiscal and monetary policy was more evident.
Also, in the 1980s, we devoted considerable effort to estimating fiscal policy’s immediate economic impact. We wanted to know – in retrospect to an unrealistic degree of precision – to what extent the annual budget would be expansionary or contractionary.
In 2015, the first budget following my return, this question no longer dominated attention. In place of short-term stabilisation, fiscal policy had now become geared to the pursuit of medium-term goals, including stabilising and then lowering net public debt over time and keeping the size of government within a reasonable revenue constraint.
I think this change of emphasis is a very positive development.
This difficult period may have exposed a degree of over-confidence and insularity in the economics profession.
Both Keynesians and Monetarists were guilty of this. We all tended to focus on favoured aggregates but may not have given enough attention to the psychological, microeconomic and wider institutional context within which economies operate.
On reflection, too often we didn’t take enough notice of the transitional costs of structural adjustment. From the comfort of Canberra, we didn’t realise the very real problems faced by people having to change jobs and residence. In recent years, we have done quite a bit of work on this in Treasury. For instance, it is clear that the ability of people to find new employment when an industry shuts down is highly dependent on their proximity to larger cities and education levels. This is not especially profound but we should have been more mindful of this during those years of rapid change.
Implicit in a medium-term approach to policy, after all, is the recognition that while your ultimate goals are fixed, your pursuit of them must take into account changing circumstances.
Medium-term goals set constraints but not straight-jackets.
Up until the GFC, there had been a range of shocks but they did not fundamentally unbalance or disrupt economies. Living standards had risen steadily, inflation was tamed and indicators of financial risk – both in Europe and the US – suggested plain sailing ahead. On the eve of the crisis, some economists were bold enough to announce the end of the economic cycle. Economists in most finance ministries and central banks were more cautious in public but in private were liable to be self-congratulatory about the stability they believed they had brought about.
Both the crisis itself and the emergency monetary and fiscal interventions that followed it in most OECD countries have fundamentally shattered this illusion.
Post-crisis growth rates, both in Australia and other OECD economies, have been building more slowly than expected and this expansion phase is not as strong as those we have seen in earlier decades. Unemployment rates have gradually come down. As labour markets have tightened, the wage growth response has been, at least until now, weaker than most had forecast. Signs of a return of inflation to the rates we would expect at this stage of the recovery remain elusive.
Views differ among economists on what may be behind these developments. Some argue that cyclical factors tell the story but that these are only operating in a muted way. Others point to structural shifts in the labour market, technological change or global factors. There is also a debate about the effect of global policy settings, both fiscal and monetary, on what we are seeing.
I do not propose to offer a commentary on these disagreements. The point I want to highlight is that, at this difficult time, there is a degree of uncertainty about our economic outlook that, in other periods, may not have been warranted.
I have said publicly that we have not uninvented the business cycle but it has changed (or is still changing) in ways we do not yet fully understand. For the period before 2008 the US business cycle averaged a relatively short period from trough to peak. And only recently are we seeing connected evidence of a solid recovery worldwide.
It has been an expansion phase with average growth rates below those recorded prior to the crisis. It has also been the case in Australia that growth since the crisis has averaged below that experienced before the crisis. But, unlike the US, the Australian economy has entered its 27th consecutive year of growth – a result that is owed to many factors – including, I believe, the medium-term policy frameworks that I have already discussed.
Both the crisis and its aftermath have challenged the pre-2008 macroeconomic orthodoxy, leaving economists in a difficult position. For policymakers, the world is a more complex and less certain place than it was before.
For both of these reasons, policymakers must increasingly feel their way.
This is particularly so given how heavily both fiscal and monetary tools were used during the GFC and its aftermath. As we all know, these interventions have left fiscal and monetary policymakers with difficult legacies: structural budget deficits and high net debt levels and official interest rates at historically very low levels.
In these circumstances, while we must stay true to our medium-term goals, considerable care must be taken in getting the transition path right.
Judgment is required, together with a healthy scepticism about what economic models alone might be telling us. There will always be some, in both academia and the media, calling for the immediate normalisation of policy settings.
But if our history is any guide, at a time of heightened uncertainty that approach carries risks. Progress towards normalisation must be made but it must be both credible and sustainable.
Treasury then and now
How has the business of Treasury changed since the 1980s?
Treasury’s role and mission has not changed. We continue to be the Government’s official economic adviser but we face more competition on this front than ever before.
There is a strong continuity in our core policy concerns. Policy fads come and go but the fundamentals of sound economic advice should not. Treasury’s focus on fiscal prudence, a competitive and open market-based economy, sound financial and other regulatory arrangements and a liberal, rules-based international economic order remain central to our work. The world has changed in fundamental ways but these represent our true North.
The department has been fortunate to serve very good Treasurers over several decades. Scott Morrison is a strong intuitive economist. Like many of his predecessors, on assuming this office he was quick to grasp the economic and policy challenges this portfolio presents. Indeed, after three Budgets and three MYEFOs, the Treasurer has both a great breadth and depth of experience.
These days I believe a good Treasurer has to operate like a highly-skilled executive chairman. They need to command the big picture but be prepared to tackle detail as well. They must initiate and lead complex and risky projects. They must be compelling public communicators but also effective negotiators and dealmakers behind the scenes. A strong Treasurer needs a good personal office.
This was the case in the 1980s and has continued to be true today.
The Treasury Secretary must make sure the department’s people, culture and way of operating meet the Treasurer’s and the Government’s needs. Again, I don’t think this has fundamentally changed over the decades. A particular priority of mine has been leading a recruitment drive at all levels to make sure we attract the best possible talent in a constrained public sector environment.
What is different about Treasury now compared with twenty five years ago?
Treasury is no longer the lone, or one of only a few, sources of economic policy advice. This is now a crowded field. On any given policy question, ministers will have access to a welter of informed and credible private sector, academic and even international views.
In this world, Treasury cannot assume it is in the box seat. Our advice can and will be tested. If what we are telling ministers is not up to scratch, its flaws and limitations will be exposed.
It is commonplace, if not a cliché, to say that public service advice is contestable but the reality is harsher than that. Poor public service advisers can be bypassed altogether.
Let me make clear that I consider competition in the market for advice to be a good thing. When the public service knows their views will not be challenged, complacency can set in. Protectionist barriers have that effect, as we all know.
Another contrast with the 1980s is that today’s Treasury deals with a wider, more complex range of policy problems.
I talked before about the difficult, post-crisis economic environment macroeconomists are dealing with. But as many of you will appreciate the tax, financial regulation, social policy and even foreign investment policy landscapes are, by orders of magnitude, more demanding than they were in earlier decades. For instance, in the 1980s it is fair to say (and I worked there) that the foreign investment area was somewhat of a sleepy hollow and the financial markets area dealt with issues which were far simpler than today.
Many of the silos that arguably could be maintained between policy areas in the 1980s can no longer be allowed to persist. Policy advice must, in many cases, draw on multiple areas of expertise, be forward-looking and, of course, be implementable.
The way the department approaches economic modelling has changed. In the 1970s and 1980s short-term econometric models were used heavily in the forecasting process and helped inform pre-budget policy assessments. Chris Higgins, Chris Caton and Neil Johnston, together with Peter Jonson from the RBA, led these efforts. Today, the department is working to improve its range of general equilibrium (GE) models. For example, Treasury staff will present our Overlapping Generations Model of the Australian economy (OLGA) at this conference tomorrow. It is hoped that these models will provide a more structured way of thinking through the effects of policy change over the medium to long run by incorporating behavioural change and identifying the channels through which policy change affects the economy. To date, it has been difficult to estimate the medium-term impacts of policy change with GE models. As, for example, they require that any reduction in revenue, such as following a tax cut, must be fully offset by an equal reduction in outlays. This mechanical financing constraint can obscure the case for change.
How can Treasury thrive in the different environment it operates in today?
To be effective we have to embrace the challenge rather than wish it away. We must be willing to adapt and change, while not losing sight of the best of our traditions.
Let me be a little more specific. First, like any knowledge organisation we need to recruit and retain the right people at all levels. Second, we must be open rather than insular and be prepared to engage with business and the wider policy communities in ways we have not always done in the past.
What kind of person do we look for in Treasury? We have always sought to recruit people who are ambitious, energetic and with a genuine love of economics or political economy. While it is easy for people to pay lip service to these qualities, they are perhaps not as commonly found as you might assume.
When I returned to the department in 2015 we focussed strongly on recruitment, both at the graduate level but also within the senior executive service. We have increased our commitment to graduate recruitment. We’ve put considerable effort into making this process more timely and I’m delighted with the quality of our intake in recent years.
We looked for and found some highly talented people from the private sector: experts in areas such as tax, corporate issues and economic forecasting who wanted to make a contribution to public policy. These private sector recruits have more than delivered on that promise. Not only have they strengthened the department’s intellectual firepower, they have brought a welcome change of perspective and outlook to what we do.
The ability to recruit at senior and middle levels has been much greater because of our Sydney and Melbourne offices. People with an interest in public policy but who also have families find it very difficult to move to Canberra. People like Lynn Kelly, Tim Baird, Warren Tease, Chris Stavrianou, Julie Greenall-Ota and Kate O’Rourke all moved from senior positions in the private sector at considerable personal pecuniary cost because they could work from our Sydney and other regional offices.
When people join the department we do not expect them all to stay for the rest of their careers. Some will make a valuable contribution over three to five years before moving onto different things. Others, of course, will stay for longer.
The second challenge for Treasury is to be less insular and more open to the world.
The offices in Sydney, Melbourne and Perth are not shopfronts or embassies but work in close collaboration with their policy counterparts in Canberra. They have also allowed us to establish a far broader and deeper network of contacts in the private sector, think-tanks and state governments. These contacts play a major part in testing policy ideas and give us a better sense of economic developments. I would humbly suggest that our good forecasting record in recent years owes much to these networks and in particular to our state and territory government contacts.
The regular Heads of Treasuries meetings have proven particularly useful, allowing participants to consider real time economic data on things like public transport usage, payroll tax and stamp duty collections.
In our private sector outreach, I have been struck that it is often smaller and medium-sized businesses which offer the best insights. The big business perspective will always be important but can sometimes (depending on the organisation and the individuals involved) sound a little formulaic and predictable in comparison.
In my view, Treasury’s place is unique. As I mentioned before, it is the official economic policy adviser to the Government of the day. This is a privilege and source of pride and motivation for Treasury staff. It is also a heavy responsibility. An academic or private sector consultant may suffer personal setbacks as a result of poor work. This does not compare to the consequences of getting critical economic policy calls wrong.