labour incomes and, to a lesser extent, capital grants. it has not involved forgoing the fundamental goals of the welfare state. in the field of pensions, in 2005 germany introduced a rule limiting the revaluation of pension benefits in periods of a rising ratio of pension beneficiaries to contributors. there is also provision for the gradual raising of the standard retirement age from the current 65 to 67 by 2029. a number of measures have also affected unemployment benefits and active labour market policies, with the aim of rationalizing the assignment of benefits and strengthening the incentives for the unemployed to accept job offers. the financing of the health system has been reformed to redistribute the costs between the public sector and patients, so as to make users more responsible. public employment costs have been curbed by reducing the number of persons employed by an average of 1. 5 per cent per year, and by even more pronounced wage moderation than in the private sector. the proposal for reform of the federal state is designed to increase the degree of financial autonomy of the various levels of government. the planning document ’ s proposal that the related parliamentary resolution indicate a ceiling for primary expenditure is a step in the right direction. this limit should be lower than or at most equal to the level set in the projection on a current legislation basis, and separate caps should be set for current and capital expenditure. in the future these caps should not apply to spending by local authorities, in whose regard the government last year redrafted the rules of the domestic stability pact, making the crucial criterion not a spending limit but a constraint on the final budget balance, so as to combine spending autonomy with fiscal accountability. it would be consistent with this approach for local authorities themselves to adopt rules on expenditure. compliance with budget constraints must be based on an appropriate system of incentives and penalties. the limits set at central level should also cover transfers to local government. special attention must be devoted to the healthcare system, which is the principal component of local government expenditure and has recorded a sharp increase in recent years. between 1998 and 2006 the ratio of health spending to gdp rose by about 1. 5 percentage points, accounting for about 60 per cent of the entire increase in general government primary expenditure. the recent enabling bill for the implementation of article 119 of the constitution lays the basis for the gradual abandonment of past spending as the standard for assigning resources to local entities in favour of standardized indicators of costs and requirements. this is the first step towards designing a system

well as to the demand side. observers conventionally assess the outlook for growth by looking at the prospects for demand components, adding them up, and then assuming that supply will respond. anything that stimulates demand is thought to be “ good for the economy ”. but over recent years, we have increasingly been reminded that it is the economy ’ s supply side performance – the quantity and quality of the capital stock, the availability of labour and the productivity with which both those factors are used – that ultimately determines its rate of growth over the long term. demand management policies – monetary policy and government spending and taxation measures designed to have a broad economic impact – can usually ensure that there is adequate expenditure to use the economy ’ s productive resources. but while we can, in most circumstances, create additional demand, it is much harder to create additional supply. unless additional supply is somehow forthcoming, however, expanding demand just produces overheating and inflation. inflation did pick up in australia during the middle years of the current decade, from 2. 4 per cent in 2003, to 2. 6 per cent in 2004, 2. 8 per cent in 2005, and 4 per cent by mid 2006. that peak in the cpi inflation rate was affected by some temporary factors, which have now reversed. but measures of inflation designed to extract the underlying trend showed a pick - up too, from about 2½ per cent to 3 per cent during the first half of last year. the most recent data for inflation, however, showed a more welcome trend, with underlying measures of inflation running at a reduced pace and the cpi rate on its way down as well. in our statement on monetary policy released about six weeks ago, our judgement was that underlying inflation would probably run at about 2½ per cent for the year 2007, which was a slight downward revision to earlier expectations. data on labour costs received since then add credence to that forecast. compared with what we expected a year ago, then, growth has turned out to be stronger, employment higher, but underlying inflation a little lower, and wages growth has been steady in the face of unanticipated labour market strength. this is quite a favourable set of outcomes, and should prompt us to ask how it all fits together. one possibility is that all we are observing is lags at work. earlier national accounts showed a weakening in growth from mid 2005 through to mid 2006. perhaps this led, with a lag, to the slowing in prices recorded in recent quarters