More transparency from Treasury needed

Comments on George Megalogenis “Hypocrisy shared, now costings reform is due”, 14/08/2010, http://www.theaustralian.com.au/national-affairs/commentary/hypocrisy-shared-now-costings-reform-is-due/story-e6frgd0x-1225905098085
Another solution is that Treasury and Finance have their models and assumptions available to all major parties that have to get their policies costed by Treasury.

While it may not politically correct and appropriate to say that the two departments may be biased politically, to have their costing as a black box is hardly satisfactory.

Just consider the change in the proposed mining tax revenue as a case. Treasury changed its assumptions and used two different assumptions for two different taxes. Was that satisfactory, or confidence building or enhancing?

Treasury changed assumptions need an explanation

Comments on Stephen Bartholomeusz “The fly in Treasury's ointment”, 15/07/2010, http://www.businessspectator.com.au/bs.nsf/Article/budget-economy-Wayne-Swan-MRRT-pd20100714-7CAML?OpenDocument&src=sph
While it is perfectly normal to change and update assumptions used in modelling or forecasting, any change or update must reflect changed circumstances.

What is unclear to the changed assumptions of commodity prices by Treasury is what had changed between the budget and its new update that has constituted material changes to cause an upward revision of commodity prices.

The world economy has not changed for better. Nor have the Chinese economic prospects.

Treasury should have an obligation to explain to the public what has caused its changes to its assumptions. Otherwise, its reputation will be seriously damaged. That would not be in the interest of good public policy advice and decision making.

Could Treasury modelling be spurious?

Henry uses Treasury modelling. That modelling uses assumptions. Those assumptions would have to be strange, either in long term prices or the share of marginal versus non-marginal mines, to produce the results he is relying on.


In econometrics, there is the term of spurious estimation.

It seems in Treasury modelling, there should be a similar term existing and applying, that is, spurious modelling.

Further, his arguments seem to be confusing. For example, he said "In the last four decades numerous predictions have been made of large scale unemployment and the death of manufacturing, decrying deregulation, decrying tariff cuts and decrying mineral booms," and "The dire predictions of the past have not eventuated, and it's unlikely that similar predictions today will fare any better."

There are reports in the last few days that stated that the government's claim that the PRRT did not affect the growth of the oil and gas industry was wrong and the growth has been from projects that do not have that tax.

So what henry is talking about? Why does he use facts, if he has, to counter those reports?

See below for Henry's arguments.

http://www.abc.net.au/news/stories/2010/05/18/2902825.htm?section=justin

This time the IMF has better insight and foresight than Aussie Treasury

Comments on Michael Stutchbury “IMF sees problems here even after global crisis passes”, 10/08/2009, http://www.theaustralian.news.com.au/story/0,25197,25906807-5017771,00.html

While the IMF has got its forecast wrong many times as any other economic forecasters did in the past, its assessment of this time seems more reasonable than the Treasury's used in the may budget. The destruction to the Australia's capacity may not be very big, but to the main OECD countries are very large indeed. This is one reason why the media term growth cannot be as those in previous recoveries from recession.

Another main reason is the inevitable adjustment to rebalance internationally, especially in the US and China in particular to their economic structures and savings and consumptions. That adjustment process of the main international economies on top of the damage to productive capacities by the great recession will see a slower world growth. That in turn will mean a slower growth for the Australian economy, both in the recovery phase and thereafter.

The Treasury needs to have another very careful examination of its assumptions used in its economic forecast. The structural parameters have changed and one cannot simply extrapolate the past experience without taking into account the new international situation.

Exchange rate and Treasury forecast

Comments on the report “Treasury chief says rise in $A could hurt exports”, 3/06/2009, http://www.businessspectator.com.au/bs.nsf/Article/Rise-in-Aussie-dollar-could-hurt-exports---Treasur-SN5EQ?OpenDocument

This is an example why Treasury forecast of above trend growth the economy used to underpin the Rudd/Swan budget 2009 was problematic and too optimistic.

They assumed Australia will benefit from China's growth, but at the same time did not make plausible assumption about the impact of China's growth on the $A. The remarkable feature of this is that it has not been long since that forecast for the $A to shoot up.

Yes, currency will fluctuate all the time, but there are some important underlying factors that should be taken into account when forecasting the Australian economy.

It was not the best course for Treasury to take to be optimistic without carefully considering the important and likely downsides. More importantly, the Treasury forecast suffered another serious drawback of the issue that was the Locus’ critique, as I argued elsewhere earlier.

Changed external environment and Treasury forecast again

Comments on report “Treasury defends eco growth estimates, puzzled by IMF forecasts”, 3/06/2009, http://www.businessspectator.com.au/bs.nsf/Article/Treasury-defends-eco-growth-estimates-puzzled-by-I-pd20090603-SN2K3?OpenDocument

Henry was again defending the indefensible of the Treasury forecast, although he had few other choices.

It was reported that Dr Henry said "When economies are experiencing weak periods of growth, it is usually the case that those weak periods of growth are followed by strong periods of growth".

But the important question is: is this a usual case? The answer is more likely to be no.

There is a synchronised global recession, or a great recession, following a severe financial crisis that almost brought the world banking system down and nearly plunge the world into depression. This is unusual rather than usual. The recession in some of the advanced economies, such as the US, UK, is a so called balance sheet recession. The Japanese experience of a lost decade in growth in the 1990s was a balance sheet recession. That may provide some food for thought for the current one in world largest economy now.

We also have another unusual situation, that is, of significant imbalance between savings and consumption in the US at least. This had not been taken seriously before the economic crisis and is taken much more seriously now and for the next few years if not the decade. There will be some adjustment of savings and consumption in the US that means likely slower than usual growth for a period due to falling share of consumption in GDP.

So by important measures, this is not a usual time or case or situation or circumstance. Treasury should have realised that. But apparent it did not, whatever its reasons. It should and in my view will be a lesson for Treasury and its top brass in economic forecast. They should heed to Lucas critique and should analyse the broad environment much more carefully. The business as usual approach does not always work.

The poor Treasurer and Treasury head should go together

Comments on Dennis Shanahan “Trio's fate now out of their hands”, 22/06/2009, http://www.theaustralian.news.com.au/story/0,25197,25669052-17301,00.html

It has been reported by the ABC that the email has been found, but it was a fake email and reportedly it was concocted within Treasury.

So, it seems that Swan should definitely be packing and going from Treasurer, not only he misled the parliament, but also the fact that the email came from within his own department.

There is also a question about senior Treasury figures, such as Treasury head and Mr Godwin Grech's supervisor. Why didn't they see the improperness of those emails sent to them and Swan's home? They are supposed to be working in the public interest both independently and not affected by political favors. There should be some heads rolling from top bureaucrats.

The Treasury has done a very poor job recently, such as the cash handouts as stimulus, the overly optimistic forecast of above trends economic growth for a number of years used in the government's 2009-10 budget. It has become too political at the expense of being independent public services.

Treasury as top economic policy agent and Rudd/Swan political spins

Comments on Paul Kelly “Spun out”, 23/05/2009, http://www.theaustralian.news.com.au/story/0,25197,25523687-12250,00.html

Yes, everything can change and it is possible that Rudd/Swan government may be forced into fiscal discipline that will required any government for the next decade to return the budget into surplus and control the government debt into the supposed low levels in the end. However, most Australians will probably have to wonder whether the current government under Rudd/Swan stewardship will be capable of achieving that. So their records have not given the public any confidence.

The public’s memory will not be very short in terms of their too big cash handouts in the face of recession and ballooning federal government budget deficits. It is also yet to see the economic and budgetary wisdoms of their proposed national broadband network at the currently costs to the tune of $43 billion, a number confirmed by the Finance minister was picked up from the air. It is noted that this is at the time of the government turning a projected budget surplus to huge deficits and an optimistically projected government net debt of $188 billion. They may think they are being heroic and with a vision to build the grandiose infrastructure for Australia and may be puzzled why the public do not see that way. For that they will forever be bewildered.

Treasury may have done its best in sketch a path to surplus. Most people understand its difficulties in doing so. And it should be commended for forcing the government make a commitment to budget restraints, although the public doubt the Rudd/Swan Labour can achieve it based its recent records. However, it appears that Treasury has been in great pain to show the public that its best is good enough.

If the Rudd/Swan government’s cash handouts were problematic in terms of their effectiveness in achieving their policy objective, then one has to wonder what role Treasury has played in those two episodes of fiscal policy dramas, given that Treasury is the government’s top economic advisor, especially on fiscal policies and affairs. Was it also so naïve as Rudd/Swan in believing the effectiveness of the cash handouts? Or was it advised against them? What would have been Treasury’s best alternatives in those times? Remember, it was not just once, it was twice in a row and the second was done after it should have been known that the first was ineffective.

In terms of the often criticised medium term optimistic economic forecast, the Treasury could have done better than that. It should have stick with its traditional forecast methodology and used trend growth rate to underlie the budget trajectory and forced Rudd/Swan to make a commitment of more stringent budget constraints, something like only 1 per cent real growth. That would have been more credible and caused the politicians to think and work harder in future budget considerations. That will force them to act more responsibly in spending taxpayers money and make less policy blunders.

To be a little more academic in questioning Treasury’s macroeconomic modelling for this budget, one has to ask whether and how Treasury had considered Lucas’ famous critique of macroeconomic modelling. To put it simply, the Lucas critique was made more than 30 years ago, and called many macroeconomic modelling back then into question. The critique pointed out that most of the key parameters used or estimated in macroeconomic modelling were variable but not structural, as a result, forecast assuming those parameters as structural was not reliable.

Treasury secretary Henry’s public elaboration of the Treasury modelling during his defence this week did not improve public confidence in the Treasury’s recent forecast modelling. He simply fell into the fallacy that Lucas criticised about more than three decades ago. Given the current global great recession and damages that causes, given the long period of de-leveraging process of financial institutions as evidenced by the Japanese case in the wasted 1990s following the burst its asset market bubbles, given the rising government debts in most industrialised countries and the inevitable trim of government spending in the medium term following the recovery, given the imminent international adjustments surrounding US savings and consumptions, there is every possibility that the world will experience a period of slow growth. That is much more likely than the probable Treasury optimistic forecast. Given all those, why was that reasonable to assume above trend growth for so many years for Australia by simply using the same past parameters to underpin that forecast? Where was the consideration regarding Lucas critique of macroeconomic modelling? Why can the public with any intelligence believe that forecast to make the budget position trajectory look better than otherwise?

The change to more optimistic, or more practical as the government or Treasury call it, forecast for future may or may not have been Treasury’s preferred initiative. But it obvious agreed to and braced it. That does not increase Treasury’s credibility of competence, and possibly independence, given the fact that Treasury, as most public servant agencies, has to serve the government of the day.

The public is not questioning just the integrity of Treasury, but more importantly also its competency following these so obvious fiscal policy blunders. The public is entitled for that. After all it is the public/taxpayers money that pays for the politicians and top public servants to look after their welfares.

Understandably Henry has to defend the indefensible

Comments on ABC news “Henry hits back at Treasury critics”, By Online parliamentary correspondent Emma Rodgers, 19/05/2009, http://www.abc.net.au/news/stories/2009/05/19/2575093.htm?section=justin

The starting paragraph reads: “Treasury Secretary Ken Henry has rejected criticism of the "optimistic" economic forecasts put forward by his department and defended its independence from government interference.”

While Henry might be right on the second point in that statement but is wrong on the first one. On the second point, while people should generally respect the Treasury for its independent advices to the government of the day, one has to be puzzled by the changes to the forecast methods used in Swan budget 2009 to underpin the budgetary positions over the course of the next decade. Were those changes the initiative of the Treasury or the government? Yes there have been reasons put out by the government and possibly the Treasury, but people’s doubt and suspicions can’t and won’t just disappear that easily just by those reasons and explanations.

Elsewhere I have commented why the Treasury forecast is too optimistic and is likely to be very wrong in this case (see http://mrlincolns.blogspot.com/2009/05/critique-of-treasury-economic-forecast.html). Although it has been some time past and most current Treasury forecast officials may have forgotten that Lucas’s critique on macroeconomic modeling using highly aggregate variables of the past. The key message of Lucas critique was that those parameters were variable and not constant and not structural. So forecast based on those estimated parameters is unreliable.

One should remember that the Lucas critique contributed to some of the revolutionary thinking in macroeconomics and the rational expectations revolution. Any macroeconomic modeler must take that into account in their modeling.

What Henry said in defending the Treasury forecast? See the following excerpt from the news report:

[Dr Henry said Treasury's method for calculating GDP used several factors, including the unemployment rate, the population aged over 15 and productivity.
"We can obtain an index of real growth domestic product simply by multiplying together those five things and that's actually what we did," he said.
"Taken together, those factors produce a GDP growth rate of 4.5 per cent."
Dr Henry also pointed out that while some critics said if the projections were realised there would be an unprecedented six years of growth, there was seven years of growth above 5 per cent in the 1960s.]

Some of the most important ones among those five things that Henry mentioned are subject to the Lucas critique. One can’t just simply do what Henry said one can do in this occasion. This recession is much severe world-wide and the recovery of the world economy is very much likely to take longer and slower. That is the first point why Henry is wrong.

The second point is that the current great recession exposed the deep problems of international imbalance in savings, consumption and investment. While in the past some people had talked about these problems, no serious actions were taken by the main parties to the problems. Now the further rising US government debts are forcing people to rethink about these problems of international imbalances. Already concerns have been raised about the safety of US government securities. There have also been reports that the Chinese, the largest US government securities holder, have recently been stockpiling metals to diversify its investment.

All these suggest that there will be an international adjustment to address or at least to mitigate those imbalances. Adjustments to savings and consumptions are not necessarily an easy matter and take time. In the processes, the world economy is likely to be adversely affected in the short term in terms of growth. In other words, it is highly likely that there will be a period of slower world economic growth as a result of addressing international imbalances. This gives the second reason why Henry is wrong in deriving the Treasury forecast.

Further, while it is possible even likely that the prices of world commodities will rise in the next few years above their current levels, but they are unlikely to rise to those levels immediately prior to their recent collapse, as a result of a slower growth of the world economy. This is unlikely to benefit Australia in terms of terms of trade to the same degree as that happened pre-recession. So growth in a few areas in Australian economy, such as company profits and investments, is unlikely to be as robust as back then. This will place another damper factor to Australian growth in the medium term.

So it is so obvious to experienced macroeconomic modelers why the Treasury forecast is too optimistic. However, it seems that it is difficult for top Treasury officials to realize them. After all, it is too late now for them to change their mind and forecast, even if some of them may realize what went wrong with their forecast in hindsight, especially after listening to some many economists’ reactions and considering carefully why other equally reputable agencies such as the RBA and IMF have got lower growth forecasts.

There are more to Henry’s talk. The following excerpt says why:

[Dr Henry also pointed out that while some critics said if the projections were realised there would be an unprecedented six years of growth, there was seven years of growth above 5 per cent in the 1960s.
"Having approached the projections exercise in this way, we were a little surprised to hear some people suggesting that our projections were too optimistic because they failed to take account of the impact of imminent population ageing," he said.]

He mentioned the there was seven years of growth above 5 per cent in the 1960s to make the point that six years of above trend growth of the Treasury forecast is not unprecedented. But it is no more than an irrelevant wining debating point, and does not really answer many of the underlying questions. For example, he did not mention whether that seven years of above trend growth were above trends of higher growth period or not. He also failed to mention other context of the 1960s, such as labour force growth, participation rates and other international/external factors. Those factors were all have an important bearing on growth.

So while it is understandable why Henry was doing what he did, it does not change the fact he is wrong in defending the indefensible – in this case the Treasury overly optimistic forecast of above trend growth for six years following this great recession and international adjustments of imbalances. As the head of the Treasury department, he has had few other choices.

Henry's last point re argument on whether Treasury "failed to take account of the impact of imminent population ageing" is probably the least concerns among economists in terms of the Treasury recent forecast. Anyone who said that would have shown a lack of understanding in economic forecasting. As a result, it was equally futile to use that point to defend the Treasury's funny forecast.

What we need now is meaning debates between those people who doubt Treasury's recent forecast and Treasury officials. One sided speeches are not really productive or helpful to the debates. It would have been better that there should have some representatives from the other side of the debates at the gathering when Henry made his speech. Maybe there were, but the report did not show it.

A critique of Treasury economic forecast for the budget

Treasury forecast that the Australian economy will grow above trend at 4.5% for a number of years following this recession. This has been used in the federal 2009 budget documents. It is said that this is based on past experiences, re those ones in the early 1990s and the early 1980s. The media and many commentators said it was optimistic, much more so than both the IMF and RBA forecasts.

While it is not uncommon to use past experiences in economic forecasts, one must realise its inherent danger if used mechanically. The famous Lucas critique should serve as a sobering reminder. Lucas pointed out that it is naïve to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data. This undoubtedly applies to the Treasury forecasts.

My critique of the Treasury forecast is that it has conveniently ignored the most likely implications of the great recession we are still having now. One implication of this recession is that there will be a much greater international effort to address the huge international imbalances in savings, consumption and investment.

A manifesto of the imbalances is the low or negative savings by the US and its huge debts. It is likely that the US has to increase savings to fund its domestic investment and government deficits. The contribution of consumption to the economy is likely to fall significantly to boost savings. This is likely to cause the US economy to grow more slowly than the case in the 1990s or in the early this century. When the world biggest economy does this, the world economy is likely to be dragged to slow somewhat. What this means is that the world economy is likely to experience a period of slower growth.

The financial crisis has caused great damages to the international banking and financing system. It needs to be repaired. Many banks and financial institutions need to deleverage and/or increase own capitals. This means the costs of capital will increase above those prevailing prior to the crisis. Higher capital costs will reduce investment and slow economic growth.

Besides the damages to banks and financial institutions, this great recession has also caused enormous damages to some non-banking companies. Some examples of big ones include GM and Chrysler that are facing a real possibility of bankcruptcy. These sorts of business failures destroy social wealth and reduce productive capacities/capital. They decrease demand through the wealth effects and reduce supply, further compounding the effects of international rebalancing of savings and consumption.

China is expected to continue grow rapidly and that is likely to benefit Australia. But even China will be affected by the expected international rebalancing. A slower US economy will limit China’s exports to the US. As a result, the Chinese economy is also likely to experience growth below its trend growth prior to the crisis.

All these point to a period of slower world growth ahead. It is against this background that I say the Treasury has probably got it wrong in its forecast by assuming above trend growth for Australia after this recession, especially for a lengthy period. It appears that it has not made the plausible assumptions on world economic growth. As a result, it has failed to take into account the changed structure of the world growth and its impact on important parameters such as world growth in its model, a point not too dissimilar to that of the Lucas critique.

It is worth noting that the government and Treasury have recently changed the conventional practice of assuming trend growth for the outer years in government budget documents. It is said that this is to make the forecast more accurately reflect the likely future course. On this account, they have either conveniently ignored the Lucas critique, or made a seriously bad judgement in the modelling process, under the understandably very strong pressure of preparing the budget.