Volume 4 NOV 2008
Feature articles When a firm is market-oriented
Accounting induced performance
anxiety
Understanding global imbalances
An interview with Robert E. Lucas Jnr.
The use and misuse of intelligent
systems in accounting
Alumni refresher lecture series
Real options analysis and
investment appraisal
New economic geography and
manufacturing
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New agenda for prosperity
How much longer can Australia’s current boom last? And how do we build the physical and human capital needed to maximise the growth of living standards as the population ages?
by Stephen Sedgwick
The context
The conference was held in the lead up to the 2008 Commonwealth Budget. After years of strong economic growth and declining unemployment, the overriding domestic economic policy concern was to contain inflation by restraining the growth of demand to a pace more in line with the economy’s capacity to supply the necessary resources. Monetary tightening and fiscal conservatism were central to this task.
A range of other policy issues were also prominent at the time. For example, rising interest rates together with high real house prices prompted debate about deteriorating housing affordability. Sustained growth had stretched the capacity of key infrastructure to cope, and there were reports of incipient labour shortages. Treasury modelling suggested that Australia’s future growth trajectory would be lower than the past 40 years unless policy changes increased incentives to work or productivity growth picked up dramatically. Debate continued about reform of education, health and the overlapping responsibilities between the Commonwealth and the States. An intense debate on climate change had focused mainly on the desirability of adopting an emissions trading scheme. Moreover there were abiding concerns about the plight of those left behind despite the sustained strong economy, with renewed interest in equity and social inclusion, including for indigenous Australians. These were amongst the issues covered during the conference.
A decoupled economy?
The fundamental conundrum for policy in the short term, however, stemmed from the fact that while Australia’s monetary authorities were raising interest rates, others were easing aggressively. This easing was intended to insulate major developed economies from credit tightening induced by the recent collapse of the sub-prime mortgage market in the US. Although inflation had edged up, the stronger fears overseas were that growth would stall (or worse) in the US and/or that financial contagion and global illiquidity would undermine prosperity in Australia. An important contextual question, therefore, was the extent to which the Australian economy could effectively decouple itself from these developments.
Two speakers, Phillip Glyde1, Executive Director, Australian Bureau of Agricultural and Resource Economics and Chris Richardson, Director, Access Economics, addressed this issue, answering firmly in the negative. After more than a decade in which Australia had benefited from an historically strong upswing in demand for commodities such as iron ore and coal, some slowing in Australia’s growth is desirable in order to rein in inflation. However, assuming sensible macroeconomic policies at home and successful policy interventions by the US Federal Reserve Board, the consensus at the conference was that any slowdown would be temporary. The Australian Bureau of Agricultural and Resource Economics (ABARE) predicted strong growth for the next five years.
Essentially, the dynamism of the developing world and its weight in world GDP were believed to provide a significant buffer against a slowdown in the US for trade-exposed economies such as Australia. Central to this was an analysis that the structure of the world economy has changed. The emerging economies now account for two-thirds of world economic growth. ABARE also argued that, compared to most of the postwar period, there is now much greater openness to world trade amongst the major economies, growth is broadly dispersed amongst the world’s economies and financial markets are more resilient and can respond well to shocks.
By 2050, China is expected to be the largest economy and account for almost one third of world output – compared to about 16 per cent currently. India is also likely to have claimed a much larger share of world output. Both countries have a very large, low-wage labour force, which will support their participation in global trade for some time. Importantly, the World Bank predicts that the proportion of the world’s population in the middle class – those earning between $US4,000 and $US17,000 in purchasing power parity terms – will treble over the next 20 years. Their purchasing power will underpin significantly higher demand for manufacturing and agriculture, minerals and energy intensive products as consumption patterns adjust to higher real incomes. This, in turn is expected to sustain strong demand for Australian exports but will also pose significant challenges to securing a global position on climate change.
Of course, risks were identified to this generally benign outlook. Both India and China have deep-seated structural problems. In the case of China, significant reform of the legal framework, the financial system and the operations of State Owned Enterprises is required. Moreover the Chinese authorities need to address economic and social inequality within China, infrastructure bottlenecks and mounting environmental problems. India has similar issues to address.
Infrastructure and incentives
The adequacy of Australia’s ports, rail, road and other economic infrastructure figured prominently in the debates. Glyde, for example, suggested such bottlenecks explain why comparatively little additional coal has been shipped from Australia in recent years, despite the strength of coal prices. He contrasted this with the more robust supply response of iron ore shippers. Several, including Ross Garnaut, suggested that the apparent infrastructure imbalances were a symptom of a broader issue, namely the strength of debt-fuelled consumption expenditure which reduced resources available for investment in infrastructure, including public infrastructure. In essence, resources had been devoted to consumption at the expense of necessary long-term investment.
The availability of cheap credit and surging household incomes contributed to this. The former owed much to a cyclical easing in monetary policy during a period of sustained low inflation from the mid-eighties, coupled with financial sector innovation. Prolonged low and stable inflation also removed some of the risk premium built into interest rates, helping to keep real interest low. Steady declines in unemployment may also have reduced the perceived risk of unemployment and reduced the precautionary motive for saving. Rising real incomes were fuelled in Australia by falling unemployment and by the unprecedented rapid and sustained improvement in our terms of trade.
However, achieving an adequate supply of infrastructure requires more than increased investment. Indeed Michael Keating, Chairman, Independent Pricing and Regulatory Tribunal of NSW, challenged whether any increase in the total value of infrastructure is required to meet emerging needs. He, and others, argued that the infrastructure dollar needs to be applied to its highest valued ends, just like any other scarce resource. At the least this requires professional, independent assessments of the costs and benefits of investment proposals. Although the methodologies are well established, they are not always well or routinely applied. He questioned whether bad infrastructure investments have consumed resources and diminished Australia’s growth potential.
Much progress has occurred in recent decades in reducing the inefficiencies of the statutory monopolies that have dominated service delivery in these areas. Even so, Gary Banks, Chairman of the Productivity Commission, reported that its annual review of the financial performance of government enterprises found that although the aggregate return on their assets has slowly improved over time, more than half still do not earn a commercial rate of return. Their investment decision-making remains constrained by undue political interference, ill defined or unfunded non-commercial obligations, constraints on pricing and restrictions on borrowing.
Institutional reform has been on the Council of Australian Government’s agenda for some years. However, several speakers argued that progress has been faltering and slow. While they supported increased public investment in some areas, Rod Sims, Director, Port Jackson Partners Ltd, for example, noted that improved pricing signals, improved access arrangements and stronger competitive pressures are also required before faster progress will occur. Several argued for faster reforms in a number of areas including not only elements of the resources supply chain such as rail, land freight and ports but also urban infrastructure (including traffic congestion), water, broadband telecommunications and climate change.
There were a number of common elements in proposals for reforms. These included the better alignment of prices and, in the case of roads, usage charges, with economic costs of supply, including all externalities imposed on others; and regulatory arrangements that promote competition and allow markets to work or to create them, say, to enable trading of rights to water or to emit carbon. Such arrangements will promote decisions that better allocate scarce resources to uses that will secure the highest returns for society and better match supply with demand at least cost.
However, some infrastructure is characterised by economies of scale that lead to natural monopolies. Others lead to externalities that cannot be captured by the provider from users, for example the reduction in road congestion facilitated by an efficient urban rail network. Governments should intervene to prevent the exercise of undue market power by natural or artificial monopolies, and to ensure that externalities that cannot be captured in user charging are adequately reflected in the financial returns earned via subsidies or required from publicly owned providers. The regulator has a delicate job to do in those circumstances. For example, while preventing exploitation of monopoly power, they need to ensure that prices are allowed to do their work. The Productivity Commission has argued that price regulation that prevents ‘above-normal’ returns may also introduce diminishing incentives to invest in long-lived assets in short supply and thus can be counterproductive at times.
Creating markets
The creation and efficient regulation of markets is a subtle policy problem. Regulations which change existing access rights or which permit the efficient trading of rights to use resources previously held in common such as water or the atmosphere not only introduce new signals to guide behaviour but also create new assets or change the values of existing ones. The adequacy of supply responses will be affected by the perceptions of investors about the security of their asset values and their capacity to earn a return on investment. Investors require predictability about the regulatory regime sufficient to make well-informed business judgments.
Reforms to the regulation of water, telecommunications and the generation of carbon emissions are cases in point. Several speakers reflected on the consequences of such realities. Competitive markets leading to efficient pricing of water and effective opportunities to trade between agricultural and domestic uses on the basis of market returns do not exist across the world: the policy and institutional challenges are clearly not easy. However, Gary Banks argued that the potential benefits are nonetheless substantial and worth the effort. Michael Keating argued that, short of establishing fully fledged markets, efficient pricing of water based on the costs of sufficient supply would substantially address existing water supply deficiencies at least cost. Indeed, he argued that Sydney’s water supply problems for the next decade could be addressed through a relatively affordable increase in domestic water prices2 to cover the expected costs of introducing water desalination and other recycling schemes.
He argued that a price set at the level of long run marginal cost would provide sufficient incentive for investment in the necessary capacity, including by the private sector. Some argued for caution and predictability in establishing a carbon emissions trading regime so as not to unsettle investment patterns in electricity generation or other pursuits that are energy and capital intensive. Garnaut argued in favour of approaches to regulation that minimise the scope for rent-seeking behaviour, relying on well functioning markets and competition to promote better economic outcomes than would be achievable by corruptible administrative fiat. He argued that his proposed approach to an emissions trading scheme would satisfy this test better than an equivalent carbon tax, once an emissions reduction trajectory has been established.
Addressing the regulatory burden
Effective regulation underpins the efficient operation of a market economy. Several speakers addressed the case for regulatory reform. Dr Stephen King, Commissioner, Australian Competition and Consumer Commission, argued that competition, not regulation per se, protects consumers. Several speakers argued that the regulators themselves and some companies have vested interests in increased regulation and complexity. It is important that the incentives are aligned to confront law makers, business and the regulators. External review mechanisms, such as requirements to subject new or amended regulations to a Regulation Impact Statement, provide an independent check on these vested interests. However some argued that these mechanisms have been ineffective in Australia, having been implemented as a check on compliance with procedural requirements rather than as substantive re-assessments of alternative approaches. Even so, Nicholas Gruen, Chief Executive Officer, Lateral Economics, argued that while Australia is not good at regulatory reform, we are, nonetheless, one of the best in the world.
Several also sought greater harmonisation, if not uniformity, of regulations across jurisdictions in Australia, claiming that Australia’s market is too small to justify the compliance and other costs associated with having different, state-based approaches to regulation, especially for nationally operating businesses. Two cautions apply, however. Capital and, increasingly, labour is mobile. A degree of competition between jurisdictions may promote improved regulatory efficiency. Moreover, the objective is to standardise on the best approach, not the lowest common denominator.
Human capital
Concerns about shortages of infrastructure were matched by concerns about the quantity and quality of labour available to support sustained strong economic growth. Industry groups had complained of skill shortages. Modelling reported in Treasury’s Intergenerational Report 2007 predicted slower economic growth for Australia in the decades ahead and an increase in the ratio of non-working to working Australians because of demographic trends, principally population aging. Policies to promote greater work force participation and higher productivity can help to ameliorate these trends.
Andrew Leigh, Fellow, Economics program, Research School of Social Sciences, Australian National University, argued that the demand for labour has increased in some industries and geographic areas in recent years as fast economic growth has become entrenched. In the short run, supply is relatively fixed, putting upwards pressure on wages in those occupations and areas. A feature of Australia’s current, more flexible labour market arrangements is that these pressures have been accommodated with less generalised impact on wage inflation and inflationary expectations than during earlier periods of strong demand. Leigh argued that the correct policy response to the prospect of continuing strong demand for labour is the introduction of measures to improve the quality, quantity and equity of Australia’s human capital, not greater intervention in the market to attempt to match specific demand for labour with supply. Such interventions would improve workforce participation and productivity.
In fact, speakers addressed reform of the education system from a number of different perspectives, reflecting the centrality of human capital formation to contemporary policy discourse. There was a high degree of commonality about their analysis and policy prescriptions.
Geoff Masters, Chief Executive Officer, Australian Council for Educational Research, acknowledged that Australia’s education system performs reasonably well in world terms. Yet there is scope for improvement. For example, compared to some countries against which we often benchmark ourselves, considerably fewer Australian teenagers reach international benchmarks of excellence in standard tests, relatively fewer complete secondary school and relatively fewer young people who have not earlier completed school undertake further education between 20 to 24 years of age. Improved teacher preparation and classroom practices, better processes to monitor the performance of individual students, a more consistent and relevant curriculum across the country and better targeting of resources to educational need are required. Rewards systems that better recognise teaching excellence and reward teachers who take on hard schools and teaching assignments, for example, in remote areas, were also strongly supported. Similarly there was strong support for higher admission requirements for student and beginning teachers.
Collette Taylor, Chair of Early Childhood Education and Care, Melbourne Graduate School of Education, The University of Melbourne, amongst others, argued that the education revolution needs to start with early childhood education and care. Lifelong learning is shaped by experiences in early childhood, and any disadvantage in early education tends to persist. Effective interventions at this early stage can help to raise average achievement levels and thus improve human capital and long-term productivity. Taylor argued that society in general is the principal beneficiary of improved outcomes from early childhood education, justifying increased public investment in the sector and better integration of education and childcare services. However, the bulk of the data on which early childhood policy is based in Australia is drawn from overseas. There is an urgent need for more research based on Australian data to support evidence-based policy development.
There are complex interactions between childcare provision and workforce participation by women of child bearing age. Participation by Australian women in these years lags that of a number of other countries, for example, Norway. Social mores contribute. So, too, do economic incentives. Access to subsidised childcare may assist to close this gap. However, Guyonne Kalb, Principal Research Fellow, Melbourne Institute, also reported evidence that developmental outcomes, especially cognitive skills, improve if a child has close support from one or both parents during their first year of life. These benefits for the child can also be long lasting. She, amongst others, argued that improved access to parental leave could reduce workforce participation of women temporarily – or encourage only part-time work – but have longer-term benefits that would strengthen the economy’s growth trajectory through stronger developmental, learning and economic outcomes for children as they progress through school, mature and enter the workforce.
Conclusion
This paper has not attempted to summarise every presentation or issue addressed at the conference. It has illustrated two key policy themes that dominate contemporary policy discourse: how much longer can Australia’s current boom last? And how do we build the physical and human capital needed to maximise the growth of living standards as the population ages? The second agenda is broad, reaching well beyond the levels of investment in infrastructure to embrace the efficiency of pricing and markets, regulatory reform, and the effectiveness of education and training. However, it also extends to a range of issues not addressed in this paper such as the efficacy of the health system, the effectiveness of administrative and economic incentives to maximise workforce participation amongst those of working age, and the quality of social capital and social inclusion. Despite several decades of effort it is clear that the scope of work still required is large.
1 This section and the next draw heavily on the presentation of Philip Glyde.
2 Keating noted that the Independent Pricing and Regulatory Tribunal, NSW, has determined that the cost recovery tariff has to rise to $1.83 per kl over the next four years in real terms (from $1.31). A typical household would then spend an additional $203pa on water, an annual rate of increase of 6.3 per cent. The price of $1.83 for a thousand litres of tap water compares with a similar price for a single litre bottle of water at the supermarket.