Volume 1 April 2007

China in international imbalances
Yu Yongding

International trade and poverty: cause or cure?
L. Alan Winters

Making the boom pay
John Freebairn

Reforming Australian industrial relations
Joe Isaac

Minimum wages and inequality
Andrew Leigh

Does the Fair Pay Commission decision matter?
Mark Wooden

The corporate political environment and big business response
Geoff Allen

Stock return predictability in rational markets
Bruce D. Grundy

Passive profits from accounting indicators
John D. Lyon

A 'Battle of Ideas'
Tom Elliott

On painting one's life picture
Peter Yates

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By John Freebairn

The 2006 Economic and Social Outlook Conference brought together 37 of Australia’s leading thinkers. Under the rubric ‘securing the next generation of prosperity’, presenters supplied answers to some pressing economic questions.

Drawing on the expertise of speakers from politics, business, not-for-profit organisations, the public service and academia, the focus of the Conference was on the economic policy challenges and options facing Australia over the next decade.

After two decades of a reform program that has transformed the Australian economy, the lucky country currently finds itself blessed by a China-driven resources boom. Previous commodity booms have ended in tears, and raise many questions. How can we manage the boom properly? What policies and strategies should Australia adopt to set itself up for continued prosperity and opportunity for all? In the process, how might we best tackle areas of entrenched disadvantage? What are the pros and cons of different options for confronting the longer term challenges associated with increased pressures on natural resources and the ageing of the population? How can we use the windfall fruits of the boom to best invest in education and training to provide skills for the future workforce in an evolving global economy, and at the same time provide for equality of opportunity?

Looking at the broader picture of economic growth, several presenters concluded that Australia has learnt to become a good manager in times of prosperity. Fourteen years of sustained economic growth has moved us up the international relative income league ladder from the bottom third of OECD countries to the top third. In part, the sustained economic growth reflects good economic management associated with the productivity gains and greater flexibility encouraged by microeconomic reforms of the 1980s and 1990s. In addition, credible monetary and fiscal policies have provided a low inflation and stable economic environment. We have better managed the housing and commodity price booms of the last decade when compared with preceding booms in the last century.

Slower economic growth

Looking to the future, there was general agreement that Australia faces lower rates of economic growth and more urgent challenges from lower productivity growth, an ageing population and new environmental tests.

Several speakers were optimistic that China will continue to experience rapid economic growth, as will other countries including India, and that global economic growth will further push the demand for Australia’s resources and maintain downward pressure on the prices of low technology and labour intensive manufactured goods and services. However, over the medium term, supply is expected to catch up with demand and current high commodity prices will fall back towards, but not as low as, historical averages. Inevitably, the rest of the traded sector of the economy will need to undergo structural change and respond to changes in Australia’s comparative advantage.

Other potential drivers of longer term structural change are likely policy responses to the challenges of climate change, and then changes in relative prices, with the possibility of carbon taxes or tradeable credits; the further development of water markets; some internalising of the costs of urban congestion; and changes in the demands by and the labour supply responses of an ageing population. Many international comparisons find that productivity in many parts of the Australian economy is below world best practice, and often by 20 per cent or more.

However, whether it is reform fatigue, complacency or because further microeconomic reforms are more challenging, over recent years governments at all levels and the general community appear less willing to accept the structural and other changes that go hand in hand with productivity growth. A new wave of productivity growth will require new political thinking and courage, and it will require governments to draw the electorate into an open and transparent discussion of the options and their comparative effects.

Unfortunately, business cycle fluctuations from the global economy and our own making are unlikely to disappear, although they may become more moderate than in the past. Also, the Australian economy of the future will have to adjust to irregular short term shocks such as droughts and other natural phenomena, and political instability in key global markets.

The benefits of the rapid economic growth of recent decades have spread to most Australians, although there are significant pockets of continued disadvantage. On average, real disposable incomes have increased by about a quarter over the last ten years associated with increased employment levels, higher wages, and some re-jigging of the tax and social security systems. Couples with children and the elderly have gained more than single adults and sole parents on low private incomes. The distribution of disposable incomes by level of income has remained fairly constant.

By conventional measures of poverty, including the Henderson measure of an income less than a half of the median, up to 15 per cent of households are assessed to be in poverty in any one year. Alternative, and arguably better, measures of poverty based on consumption or on income over several years reduce the measured incidence of poverty to around seven per cent of households. More graphic signals of particular pockets of unfairness include the statistics for indigenous Australians (with very much lower life expectancy and school completion rates, and much higher unemployment and incarceration rates), the 100,000 homeless, the 700,000 children in households where no one has a job, and long waiting lists for public dental care. Low capabilities, particularly of education and health, were shown to be highly correlated with, if not causal forces of, those not sharing in the fruits of the boom. Perhaps of most concern is that such measures of extreme disadvantage have, if anything, become larger in recent years, and in terms of the policy debate there is concern about whether we have the policy levers to achieve significant changes for the better.

Education opens doors

Education was pinpointed as critical to both future prosperity and equity in many sessions of the conference. Here, education extended from pre-school and school to vocational and tertiary education. Skilled labour – as the largest production input by cost – will become even more important in the future to support higher labour productivity and real wages in an evolving and more competitive global economy.

Links between the quantity and quality of education on both participation and productivity rates that drive the level of GDP and its growth rate are now well established. At the individual level, there is ample evidence that more educated people experience higher employment rates and lower unemployment, higher wage rates, better health, and more agreeable social lives. Education for both economic growth and equity has to be seen as a long term investment with high rates of return – probably in excess of 20 per cent.

On several criteria, the provision of education in Australia was found to be deficient and falling behind world’s best practice. Australian funding of education as a share of GDP is in the second half of OECD countries. In terms of outputs, Australian completion rates for secondary schooling and tertiary education are below the OECD average, and 20 per cent below the best performers. For example, and perhaps of most concern, is that a third of students did not complete secondary school, and for those who did not complete year 10, only a half of those of workforce age were employed.

Many suggestions were made to change policy towards education over the next decade, affecting pre-school, school and vocational and tertiary education. More funding, while clearly important and requiring better delineation of Commonwealth-State responsibilities, was only a part of the picture. Other areas of structural change to address included: enhanced community and other support for parenting; curriculum; a better pay and career structure for teachers; opening up greater competition between alternative suppliers, providing more autonomy to providers who are more accountable for education outcomes, and allowing for specialisation among providers; and providing funds more attuned to the needs of individual students and the different costs of supply.

In many cases the links between different actions and outcomes are not well understood, and several speakers emphasised the need for experiments, measurement and monitoring to improve knowledge of what works better.

The combination of technological change and an ageing of the population is expected to increase the share of GDP allocated to health and aged care to well above the current 10 per cent, with much of this growth being government-funded. While the current arrangements, together with the importance of equity objectives, make major structural reforms for incumbent governments a daunting task, the independent speakers argued that considerable efficiency gains in the costs of the supply of health and aged care are available. In particular, there are costs of duplication and overlap between the different levels of government.

Other candidates for policy reform within each level of government were also identified, notably unclear and confused objectives, the lack of appropriate incentives in payment schedules facing public-funded suppliers to improve efficiency, and inconsistent regulations, especially for aged care.

Current policies towards the environment, including water, greenhouse gas emissions and urban congestion were placed high on the reform agenda over the next decade. While these are areas of classic market failure, speakers argued that where possible a combination of market forces and government interventions to internalise external costs was desirable. Prices reflecting social marginal costs elicit private information on preferences and new technological opportunities in reaching better allocations of scarce natural resources, and they provide incentives and rewards for investment, including R&D, to expand supply at minimum cost. Government inaction creates uncertainty and defers required investment, which, in turn, hampers both economic growth and the achievement of better environmental outcomes.

Inter-government coordination

A key to achieving improved productivity in the future repeatedly turned to the area of Commonwealth-State (and to a lesser extent Local) government relations. In the areas of health and education, regulations, finances, water, other infrastructure and climate change, many speakers took the view that the current system is a major block to future prosperity.

Current arrangements are characterised by unclear and questionable objectives with government policies, overlaps, duplication and complexity, unwarranted differences and excessive regulation, and lack of accountability, buck-passing and blame shifting between the different levels of government. It was conceded that the constitution will not be changed, and therefore any solution must involve continuation of the three tiers of government working together in more effective ways.

Within this constraint, a number of ideas were suggested as options for further consideration. These options included: referral of powers to one level of government to improve accountability and reduce overlapping responsibilities; and greater cooperation between the different levels of government accompanied by measurable, transparent and accountable objectives of performance. The cooperative model may need to be supported by independent performance reviews which provide for financial incentives and rewards, and by an independent body charged with providing the different levels of government with research-based assessments of the case for government intervention, the form such intervention should take, including which government level does what, and ways to measure and monitor performance.

Other potential roadblocks to prosperity discussed at the conference were the supply of appropriate skills and infrastructure. In both cases it was proposed that market forces be given the primary role in signalling areas of relative shortages and in providing the incentives for additional investment in both human and physical capital. In the case of workforce skills, this means allowing relative wages to vary over time, and in the event of higher wages for particular skills and regions of labour scarcity not to have these increases flow onto higher wages in other parts of the economy.

In some cases more flexible and family-friendly work conditions can be as, or more, important than higher wage rates. Supportive government policies can provide information, ensure recognition of qualifications, provide funds for people to gain generic skills (as grants or as income contingent loans), actively encourage competition and innovation in the supply of training, and assist the short term bridging of areas of particular skill shortages via immigration. In the case of physical infrastructure, where government regulations are imposed, it was argued that they should be based on sound principles of demonstrated market failure, and that they be national regulations. It was recognised that markets will not always anticipate areas of infrastructure and skill shortages, but they are likely to make less mistakes than government planners, and when forecast errors are made, markets provide their own corrections.

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