Government must lower our great expectations

THE Gillard government fights something more ugly than winning acceptance of carbon pricing - it confronts a structural shift in which wealth per person has been static for five years, making people cautious, frustrated and angry.

This shift defines the mood of the nation, and resentment towards Julia Gillard as PM. It is tied to a paradox that makes people agitated about the public debate. Australia's economy is growing strongly but households feel anxious because wealth (not income) is under pressure.

The evidence is apparent: house prices, the main source of wealth for people, are sliding. The sharemarket is down. Superannuation accounts, having been boosted for 25 years, are under pressure or in negative territory. There is a new age of the cautious consumer, more ready to save than spend, to discharge debt than borrow to buy new assets.

"Real household assets per head today are about the same as they were five years ago," Reserve Bank governor Glenn Stevens said last week in his "glass half full' speech. By coincidence, that covers exactly the Rudd-Gillard era that began in 2007.

An extraordinary rise in Australia's wealth began about 1995, the time that John Howard became PM. Stevens says gross assets held by households more than doubled between 1995 and 2007.

It is a remarkable statistic. "It was no coincidence that households felt they were getting wealthier," Stevens said. The value of homes rose by more than 6 per cent each year in real terms.

People felt richer, and they were richer. Maybe they even felt a touch "relaxed and comfortable". The public kept re-electing Howard and Peter Costello. It was a very good time to govern. But Stevens highlights the unsustainable nature of this wealth effect.

We could call it the "Howard-Costello wealth effect", not necessarily because they caused it but because it defines their era.

What did it involve? It meant household spending grew faster than income for a lengthy period up to 2005. Gross debt compared with annual income rose from 70 per cent in 1995 to about 150 per cent in 2007. Obviously, this had to end.

"It is still not generally appreciated how striking these trends were," Stevens said. "It is very unusual in history for people to save as little from current income as they were doing by the mid-2000s. And it is very unusual, historically, for real assets per person to rise at 6 per cent or more per annum."

It was also "very unusual" for people to withdraw equity from their homes to use for other investment and spending.

In cultural terms it was the age of entitlement, and the entitlement culture was given a turbocharge from 2003 with the China-driven terms of trade explosion. Year after year the terms of trade increased, usually more than Treasury expected, generating a huge boost in Australia's national income and wealth.

Howard and Costello disagreed on how to distribute this income, but it was divided three ways: a budget surplus, tax cuts and more government spending and cash to households. Yet the terms of trade entitlement also was unsustainable because, eventually, they had to plateau or ease back.

What was Australia's condition in 2007? It was fat, happy and entitled. It was in no mood for Howard's Work Choices shock - telling people they might have to accept removal of some work entitlements in the cause of reform.

His demise testified to the power of the no-losers culture. Any politician mug enough to propose a reform that delivered losers faced execution by a nation satiated on expectations. The luxury of Australia's obsession with climate change from 2004, reaching its zenith around 2008, cannot be explained without reference to the wealth effect.

In her current Quarterly Essay, "Great Expectations", The Australian Financial Review's Laura Tingle argues that politicians have boosted expectations in their vote-buying techniques and that the power of state paternalism, long embedded in our political culture, is alive and well. She is right on both counts.

The demise of Kevin Rudd was dominated by new peaks of expectation about what government can achieve. In truth, Rudd's goals were impossibly high - fixing the federation, the Education Revolution, pricing carbon, saving Australia from the global financial crisis, a mining tax, a National Broadband Network, new hospitals reform, a Fair Work Act and much more. By pledging so much, Rudd doomed himself.

Yet Labor continues to inflate expectations. In fact, it is trapped in a near impossible bind: it must expose Tony Abbott's negativity on the economy yet avoid setting expectations at a level that only further alienates the community.

The turning point in the expectations debate was the GFC. Yes, Australia survived without recession. Yes, income growth remains buoyant. Yet the situation for households has been transformed. Stevens laments that public discussion is "unrelentingly gloomy" despite economic growth above 4 per cent.

The explanation he offered lies not just in the two-speed resources boom economy but in the structural shift for households.

People don't feel richer now, and this sentiment may last for some time. Housing prices may remain weak. The shift to prioritise savings is rational, but because people aren't spending they feel poorer. Stevens doesn't expect the high asset prices and high borrowing of the pre-2007 era to return.

That story is over. When wealth does rise again he expects asset values will grow only at about 3 per cent in real, per capita terms, not 6-7 per cent.

While people are adjusting behaviour, their expectations resentment is real and it is being vented against governments.

In this context, Stevens had a harsh policy message - the Reserve Bank will not run a soft interest rate policy "to try to engineer a return to the boom". The economy needs the "right sort of confidence", not phony confidence based on runaway house prices and excessive leverage. In short, don't mistake the purpose of the current interest rate easing.

This is an exercise by Stevens in expectations management. It is reminiscent of the warning of Treasury chief Martin Parkinson that building budget surpluses in coming years will require politicians to increase taxes or further cut government spending. That means only one thing: reducing public expectations to the new reality.

In retrospect, Labor should have used the global crisis, the deepest downturn since the 1930s, to transform public expectations about entitlements instead of telling the nation nothing would change and its entire program would be delivered.

Labor has a good economic story to tell today, but it can be sold only in a climate of reform that is tied to lower expectations.