Dog Days: Australia After the Boom (Redback) (10 page)

New opportunities for the expansion of Australia’s exports to Asia include processed foodstuffs, specialised manufactures, and services in education, tourism, engineering, business, architecture, law and medicine. For all of these exports, our relative proximity to international markets confers advantages. For services, our location within similar time zones to Asia confers special advantages over the developed countries that are our main competitors.

However, Australia’s advantages for the new export industries are not unique and overwhelming as they are in iron ore, coal and, for the time being, natural gas. Australian suppliers of non-resource goods and services will be engaged in intense competition with exporters in developed countries all over the world, countries whose competitiveness has been honed by hard times since the Great Crash of 2008.

It is a great advantage that we are well placed to make use of new opportunities in the Asian Century after the China resources boom. But from now on we will have to earn our luck.

A SUCCESSFUL STRATEGY BASED ON REAL DEPRECIATION

A strategy to restore full employment with the highest possible living standards contains the following elements.

First, interest rates are reduced until the dollar has fallen enough to rekindle investment in the export- and import-competing industries. Special measures may need to be taken to prevent low interest rates from leading to inflation in housing if this is seen to be rising imprudently. Other measures are considered if the exchange rate stays high.

Second, the government seeks broad public support for conversion of the fall of the dollar into a real depreciation. This will require steps to ensure that the burden of adjustment is shared fairly.

Third, the government stimulates the economy by investment in productive infrastructure.

Fourth, a programme of uninhibited productivity-raising reform is developed, as discussed in the next two chapters.

Productivity relates to the amount of economic value generated from a given amount of labour and capital. Productivity as conventionally measured only makes sense for the production of goods and services exchanged in markets. The ownership of producers can be public or private so long as the goods and services are exchanged and given a value in the market. Productivity, in this sense, relates to about two-thirds of today’s Australian economy.

The American economist Paul Krugman famously said that productivity isn’t everything, but in the long run it’s almost everything. But the short and medium run also matter, and in these timeframes participation in the labour force has quite a lot to do with whether average incomes rise or fall. We add significantly to average incomes if we encourage Australians into the labour force and then allow them to have as much paid work as they prefer to do. Participation affects economic output but not productivity as conventionally measured. The employment of more people for more hours enhances output, welfare and equity. Yet it may reduce productivity, since it may increase the labour supply by proportionately more than it increases output – as it did when workforce participation grew rapidly in the 1980s. (I discuss participation in Chapter 7.)

The idea of productivity can be applied to non-market services within the public sector. However, there is a danger that any particular measure of value for these services provided by government will be arbitrary, contentious and liable over time to give a false sense of precision. I prefer to talk about the
effectiveness
of the public sector, so that we are not pretending that we are dealing with anything precise. (Effectiveness of government is the focus of Chapter 8.)

I use the term ‘living standards’ many times in this book. I am only referring to the consumption of material goods and services. It should go without saying – but sometimes needs saying – that material living standards are not the only determinants of human welfare.

When I talk about achieving full employment with the highest possible standard of living, I am referring to a standard that is sustainable in future – a standard enjoyed by Australians now that can also be provided for those in the future. Adjustments to lower standards of living are difficult, painful and disruptive. When we think about it, not many of us are comfortable about enjoying a level of consumption of goods and services that cannot be passed on to those who follow us – in the next decade or the next generation or the generation after that. People living at one time can always consume more goods and services than will be available to those who come after them by running up high levels of private and public debt (which is especially difficult for the future if it’s funded by foreigners), or weakening the institutions upon which our civilisation depends, or damaging irreparably the natural environment. But when we see that we are living unsustainably, the decisions that allowed it are invariably regarded as a mistake, resulting from a lack of information or failure of analysis or failure of our political system to make choices that reflect the underlying preferences of most Australians.

The difficult adjustment that we are facing now is actually an example of Australians at one point in time – those living through the China resources boom of 2002–11 – enjoying standards of living that have turned out to be unsustainable. Our failure now to deal with the problems that have accumulated since the turn of the century will compound the problems that Australians will have to deal with at some later date. A more fundamental contemporary issue of sustainability, the mitigation of climate change, is the subject of Chapter 9.

WHY AND WHERE PRODUCTIVITY IS FALLING

Australia is fortunate to have excellent public institutions with authority, analytic capacity and independent standing that measure, analyse and provide information on productivity and how it changes over time. Between them, the Australian Bureau of Statistics and the Productivity Commission publish information for policymaking that is superior to that available in almost any other country.

I will use the terms ‘total productivity’ or simply ‘productivity’ to avoid repeating the mouthfuls of ‘total factor productivity’ or ‘multi-factor productivity’. I will also use the term ‘labour productivity’ to mean the value of economic output for each unit of labour input.

For most of our history from Federation, Australia’s total productivity growth was unimpressive by the standards of developed countries. That is why we gradually slid down the world league tables for average standards of living, from the top to the lower middle, through the first eight decades of the twentieth century.

That all changed in the Reform Era, and for a while in the 1990s we enjoyed the highest productivity growth of all developed countries, as discussed in Chapter 5. Productivity growth then slowed down sharply. There was no growth at all from 2003 – an early year in the Great Australian Complacency and the beginning of the China resources boom. From 2006 until 2010–11, the latest year for which we have data, total productivity fell.

The narrower measure of labour productivity behaved differently. Labour productivity growth also fell from early in the twenty-first century, but not by as much. And it has picked up recently, returning to high levels in 2012.

Total productivity is the better measure of contributions to higher living standards. Labour productivity can rise either because capital and labour resources are being used more efficiently, or because the amount of capital provided to each worker increases. Capital has a cost, and it is not certain that rising labour productivity from the use of more capital increases living standards. But an increase in the efficiency with which both capital and labour are used – total productivity – unequivocally leads to higher incomes and living standards.

The Bureau of Statistics and the Productivity Commission have recently shown that the decline in total productivity from 2007 to 2012 was concentrated overwhelmingly in four big sectors: mining, utilities (mainly electricity and water), manufacturing and financial services. In the last year for which we have data, 2011–12, productivity had turned around and was growing again in manufacturing, but was sliding even more rapidly in the three other areas.

The declines in productivity in mining and utilities are shocking. Productivity fell at an average rate of 8.4 per cent per annum in mining and 4.5 per cent in utilities from 2007–08 to 2011–12, and by 10.5 per cent and 5.4 per cent respectively in 2011–12. Outside these industries, productivity was merely stagnant.

The causes of falling productivity are different in each of the four sectors. For mining, it was an immediate consequence of the resources boom. High resources investment adds to the capital stock immediately but to production volumes only over a number of years. This shows up at first as declining productivity, and is partially corrected later as capital expenditure falls and exports increase.

Much investment in the boom has been highly productive and has increased the value of the companies that have undertaken it. Some has been wasteful and has been written down with the retreat of the boom through 2012 and 2013. The productive and the wasteful investment alike reduce productivity in the short term. This picture changes when operations commence from the productive new capacity. The wasteful investment continues to weigh down productivity (although not productivity growth) until its depreciation many years after the initial expenditure.

Productivity in mining has also been reduced because management pays less attention to containing costs when prices are high and margins prodigious. The good reason for doing this is that when profits are extremely high, it makes sense for management to put more effort into increasing production; the bad reason is the human tendency to apply less rigour to reducing costs when things seem to be going well. Difficult tasks that do not need to be done are less likely to be done. This ‘less attention’ source of declining productivity is corrected when falling commodity prices cause managers to shift their focus to cutting costs. This has been occurring with speed and intensity through 2013.

Finally, the large expansion of mining production in the third phase of the resources boom involves bringing lower-quality mineral deposits into production. This also reduces productivity.

The resources industries are highly competitive and operating within an international environment. The spectacular decline in productivity through the boom will turn around in the period ahead (without productivity returning to its old levels) and does not represent a serious problem for the Australian economy.

By contrast, the decline in productivity in the utilities and especially in electricity
is
a problem. It is a recent phenomenon, dating from early this century, with the biggest deterioration occurring since the introduction of new regulatory arrangements in 2006. There has been more than $100 billion of capital expenditure on the utilities over the past four years. (This investment is several times the expected cost of the National Broadband Network in the whole period from commencement in 2010 to expected completion in 2021.) Yet while new investment has been immense, output from the utilities has declined.

It is argued that large investments have been necessary in recent years to improve the reliability of supply, including by remedying underinvestment in the networks in earlier years. There is a little in that argument – which then suggests that part of the gain in productivity that the Bureau of Statistics, Productivity Commission and I have claimed for the first decade of privatisation and corporatisation in the 1990s was illusory.

For electricity, it is argued as well that the regulation of carbon emissions and the expansion of renewable energy have reduced productivity. That is a small part of the story. The proliferation of small programmes to reduce emissions from about 2005 had some negative effect. The replacement of the smaller schemes by carbon pricing and the broadly based Renewable Energy Target will allow emission reductions with smaller losses.

A bigger story is that the authorities have imposed reliability standards – for example, on the expected frequency of electricity blackouts – that bear no close relationship to economic value or community preferences. But the factor accounting for most of the wasteful investment in electricity is flawed regulatory arrangements. The flaws could be readily and rapidly corrected, although not without political difficulties.

What about water? Here, the marked reduction in winter rainfall and run-off into dams in southwestern Australia at least is recognised by climate scientists as an early footprint of human-induced climate change. Changes in patterns of rainfall and run-off have affected the old water-supply systems for all of the large Australian cities. Questions can be asked about whether the two desalination plants installed in Perth and one each in Adelaide, Melbourne, Sydney and Brisbane were the most cost-effective responses to the decline in old patterns of river and stream flow into the dams. Whatever the answer to that question, any response to the changing climate that provided reliable water supply to large cities was going to involve large costs just to match the output levels of the years when rain-fed dams did the job. Now that the desalination plants have been built, they will provide the necessary supplementary water-supply capacity for a number of years and cease to be a drag on productivity growth.

Financial services and insurance is the largest sector covered by the Australian Bureau of Statistics’ measurement of productivity. There are significant barriers to entry in these industries, some of regulatory origin. Competition has declined in the aftermath of the Great Crash of 2008. As in mining, high profit margins have reduced the pressure to cut costs.

There are opportunities for improvement over time through increased competition. The sector should be attractive for new players, with higher profit margins and rates of return on capital than anywhere else in the developed world.

For manufacturing, the decline in productivity is partly a consequence of the resources boom. The high real exchange rate has been reducing domestic and international sales, and these declining sales are spread over a fixed capital base. From the second quarter of 2013, the improvement of Australian competitiveness through the depreciation of the Australian dollar can be expected to expand sales.

Most of the manufacturing sector is operating in a highly competitive global market, in which there are powerful incentives to absorb efficient practices. Corners of the sector, however, remain or hope to become protected by higher tariffs, anti-dumping and local procurement arrangements, subsidies from commonwealth or state budgets, or idiosyncratic local standards. The aftermath of a large real depreciation in the exchange rate would provide a congenial economic as well as political environment for the swift removal of all remaining barriers to free international trade.

So the four sectors that have contributed most to the productivity decline of the early twenty-first century are in the process of considerable if incomplete correction (mining); would be set upon a path to correction with a large real depreciation of the Australian dollar and the removal of remaining protection (manufacturing); would see a radical improvement in productivity through reforms that are technically straightforward but politically challenging (utilities); or will face large productivity problems for which increased competition would seem to be a necessary part of any solution (financial services).

HOW TO RAISE PRODUCTIVITY

Recent studies have identified many opportunities to increase productivity across the Australian economy. There are a few opportunities for transformational gains, but for the most part we are looking at large numbers of modest incremental gains. The latter can add up to large and eventually transformational improvements, but that will take many years of effective effort.

Each step in productivity-raising reform is politically difficult in isolation, with the gains from each seeming too small to warrant the political effort and cost. Success is much more likely if many productivity-enhancing changes are presented together as a large programme of reform. Vociferous critics of single steps will have difficulty in arguing public-interest reasons for opposing the programme as a whole. Many of the opportunities for improvement will also require reform of our federal system (as discussed in Chapter 7).