Monday, September 1, 2014

How the econocrats can lift their game

When we judge the performance of chief executives, most of us know the boss who's good at cutting costs isn't worth as much as the boss who's also able to improve the outfit's products and processes. Well, the same goes for treasurers and finance ministers - and their econocrats.

It seems the fiscal managers are running low on good ideas. But not to worry - the former Treasury and prime ministerial adviser Dr Ric Simes, now of Deloitte Access Economics, had some useful advice to offer in a speech to the Australian Business Economists last week.

Simes argues governments themselves have an important role to play in achieving the improved productivity performance the econocrats keep saying we need. Especially when "productivity" is better thought of as "technological progress" and the figures for measured productivity aren't as important as actual improvements in welfare.

"For those parts of the economy where market forces are paramount, government's main role is to make sure that regulation or its own actions allow competition to unfold without unwarranted intervention," Simes says.

To me, this means econocrats should urge their masters to tread carefully when powerful business interests, fighting to shore up a technologically superseded business model, demand that governments make breaches of government-granted copyright a hanging offence.

As Simes says, digital technologies have lower entry barriers and are forcing businesses to be both more productive and more responsive to consumers. So don't help incumbents resist change.

But, he says, the potential for technology to make some of the largest improvements in Australian lives lies in government-heavy sectors including health, education and transport. In these areas, progress has been too gradual.

"The exemplar is probably electronic health records, which have been the focus of considerable effort for perhaps 15 years now, but where we still seem to be a long way off the goal of having them routinely used throughout the health system.

"Or, take even an example where we have done well, the SCATS - Sydney Co-ordinated Adaptive Traffic System - for control of traffic lights. SCATS was originally developed 40 years ago, it has been constantly refined since then and is now in use in 27 countries.

"So, a success story - yet, as a Sydney driver, I know my welfare would be improved with a more refined SCATS system. It's coming - NICTA [the National Information Communications Technology Research Centre of Excellence] and others are working on optical-based monitoring and improved optimisation algorithms - but more support for both the research and especially its deployment would lift my welfare!"

Simes notes that in both cases, electronic health records and SCATS, the strict efficiency improvements from the technology - the bit that would help government budgets - represent a relatively small part of the overall benefits to the community.

"Especially in health and education, many of the benefits will involve improvements in the quality and range of services rather than efficiency gains," he says.

"Making the most effective use of digital technologies in health and education - as well as other areas where government has a direct role, such as smart technologies in transport and utilities - will deliver much larger economic and social benefits than where we seem to like to focus much of our policy attention, such as whether we should get the budget back into balance by 2017 or 2019."

Another potentially major area of micro-economic reform, Simes says, is how we organise our cities. Up to 80 per cent of Australia's output and employment occurs within its major cities. This has happened in the pursuit of economies of agglomeration.

"Yet we know that the problems are mounting. Congestion, compromised open spaces, the loss of amenity all risk detracting more and more from those benefits."

As with digital, many of the benefits from fixing these problems would not show up in our standard measures of welfare derived from the national accounts.

"Ten minutes less travelling time to work, or to school, doesn't have direct effects on gross domestic product. A more vibrant space around the harbour, or convenient shopping centre in the 'burbs, doesn't get picked up. But social welfare is clearly affected," he says.

Taking Sydney as an example, if commuter travel times on its roads were reduced by five minutes per trip, the benefits would amount to $3.6 billion a year, if an individual's time is valued at average weekly earnings.

To this you could add savings for freight or commercial vehicles. And savings for going to the shops, or school, or to the beach.

Echoing the patron saint of treasurers, Simes wants to lift our gaze to "the big picture".
Read more >>

Saturday, August 30, 2014

Digital revolution transforms productivity debate

A second former econocrat has joined former secretary of the Prime Minister's department Dr Mike Keating in seeking to lift the tone of the economic debate.

"We are spending too much effort debating how and how quickly we should bring the Commonwealth budget back into balance," Dr Ric Simes said in a speech to the Australian Business Economists this week.

"We need to elevate the economic debate from the level of catchcries about debt and deficits, or about productivity or even about the use of cost-benefit analyses. We need some deeper analyses being brought to the surface."

Simes, now a director of Deloitte Access Economics, formerly of Treasury and economic adviser to Paul Keating as prime minister, wants to see a more sensible discussion about productivity.
Productivity is obviously important and policy should indeed be focused on lifting it.

"But we do need to be careful about what this may mean in a particular circumstance," he said. One problem is that productivity is being used as a catchcry for myriad causes, often unjustifiably.

Simes agreed with Mike Keating's trenchant observation that "business associations, some leading employers and their camp followers in the media are insisting that future reforms must focus on alleged labour market rigidities and reductions in taxation, as if these were the most important influences on productivity".

And while "there is scope for improved labour relations to make a modest contribution to improved productivity ... the main responsibility for improvements in that regard lie with employers themselves," Keating has written.

"The best thing that employers and their trade associations could do is to stop passing the buck to everyone else for their own failings, and get on with making their workplaces more productive using the existing freedoms that they undoubtedly have," Keating concludes.

Simes adds that this is exactly what most businesses try to do. For his evidence, keep reading.

Simes' second problem with how "productivity" is being used in the debate concerns its measurement. "Productivity is simply a less than perfect measure of economic wellbeing, and having the public debate focus so much on what the Bureau of Statistics reports as productivity can be unhelpful."

Indeed, Professor John Quiggin, of the University of Queensland, had called productivity an "unhelpful concept", mainly because of problems with the way the contributions of labour and capital were measured in its calculation.

Simes agreed with Quiggin that we'd be better off using a term that was closely related to productivity, "technological progress" - that is, the introduction of technological innovations such as new products and improved production technologies.

Rhetoric - the choice of terms - did matter, Simes said, and had we been using the term technological progress instead of productivity, the debate wouldn't have been so open to distortion by vested interests.

"Tax, or industrial relations, or fiscal policy, can and should be refined, but they are not at the heart of why measured productivity weakened after 2000," he said.

But the measurement problem went further. "I think we have a fundamental problem in that our measures of gross domestic product or productivity are becoming less reliable proxies for economic welfare."

If instead of looking at productivity statistics we stand back and look at the way societies and businesses are changing, we find some profound changes under way, particularly the digital revolution.

We see consumers forcing retailers and media companies to transform. His own research had found that, without telework, only 14 per cent of new mums said they would return to work with their old employer, but 61 per cent said they would if telework was available.

His research had found how companies' information technology policies on staff use of social media at work and BYOD - bring your own device - were of growing importance in attracting young and talented employees.

He'd found that businesses able to create a "collaborative" working culture - including through use of digital technologies - succeeded in growing faster than otherwise.

What has this to do with productivity? First, most of the change we were seeing was being driven by individuals, whether they be consumers, workers, students or patients. To a trained economist, this should suggest that economic welfare had probably risen - and risen a lot.

It was hard not to conclude that individuals making deliberate decisions to do something new were adding to their own welfare, and to society's.

But, second, if this isn't showing up in our measures of welfare - such as GDP or productivity - then maybe there was something wrong with those measures. It seemed to Simes that "productivity, as measured, misses many, if not most, of the gains to consumer and social welfare that digital technology is delivering".

It didn't capture the benefits from improved convenience when we no longer had to queue for ages to renew a licence or at our bank branch. Nor the convenience of being able to search for a needed service in a fraction of the time it took before the internet.

It didn't capture the benefits of much greater choice. The Amazon books site, for instance, took costs out of the supply chain (thus reducing prices to consumers) but also provided much greater choice of books in a convenient manner.

Studies by Erik Brynjolfsson and others at the Massachusetts Institute of Technology had estimated that the easy access to a greater choice of books generated seven to 10 times the consumer welfare that the more efficient supply chain generated (the only bit that would make it into measured productivity).

He wasn't saying we should include the benefits of convenience and choice in our measurement of GDP - that wouldn't work.

No. "What I am arguing is that we need to be careful to base policy decisions on a deeper understanding of our objectives and not be driven by simplistic rhetoric," he said.
Read more >>

Wednesday, August 27, 2014

Why almost all of us are 'out of touch'

When politicians say things such as that the poor don't buy petrol, it's easy to accuse them of being "out of touch". Actually, all politicians face that accusation before they're through. It's one of our favourite things to say about pollies we disapprove of.

But let's turn it around: exactly how in touch are you and I? Much less than we imagine.

We know a lot about our own circumstances and those of our friends and neighbours, but are surprisingly deficient in our understanding of people outside our circle.

And one of our greatest deficiencies is our inability to see ourselves as others see us, to place ourselves on the spectrum. Take the question of income.

In 1999, researchers at the University of NSW conducted a survey asking people to nominate their family's gross income and then to say where they believed that income placed them in the distribution of all families' income.

The results showed that more than 93 per cent of respondents believed their income to be in the middle 60 per cent of the distribution.

Most of us like to imagine we're middle-income earners. Ask us where we fit and almost no one admits to being either rich or poor (unless they're accused of not using much petrol).

A survey conducted this year for the Australia Institute, found a similar result but put it a different way: nearly all Australians think the average income is the same as their own income.

Of those respondents reporting their own annual household income to be between $20,000 and $40,000, 58 per cent believed the average income of all households lay within that range.

For those on $40,000 to $60,000, 71 per cent thought this was average. For $60,000 to $80,000 it was 61 per cent, for $80,000 to $100,000 it was 55 per cent, and for $100,000 to $150,000 it was 51 per cent.

Even for those on more than $150,000 a year, a third of them thought that was average. According to the Australian Bureau of Statistics, the average household income in Australia is $80,700.

But how could so many of us be so out of touch? How could we be so unaware of how the other half lives and which half we fit into?

I'm sure there are various reasons, but one of the big ones is something that's been going on for years without most of us noticing. Our cities are becoming more socially stratified, with the better-off congregating down one end and the less well-off down the other.

These days, you're less and less likely to find suburbs with a cross-section of high and low income-earners, or highly and lowly educated people.

So we don't know how the other half lives because they are in the other half - the half we live far away from and rarely visit or even drive past. Pretty much all our family, friends and workmates are in the same half we're in.

A study conducted last year by Jane-Frances Kelly and Peter Mares, of the Grattan Institute, Productive Cities, looked at maps of who lives where in Australia's largest cities and tracked how this had changed in the 20 years between 1991 and 2011.

The authors found that the residents of our four biggest cities have enjoyed rising incomes and have become much better qualified. At the same time, however, our cities had become more polarised.

"Increasingly, high-income residents with university-level qualifications cluster in suburbs close to city centres, while residents on lower incomes, and residents with vocational [trade certificate and diploma] qualifications, are more likely to live around the city fringes," they say.

"In each city, it is also possible to identify particular areas of disadvantage, where a high proportion of residents have no formal qualifications beyond secondary school, where labour market participation is low and where a high proportion of young people are 'disconnected' - that is, neither working nor engaged in education or training."

In Sydney and Melbourne, individuals on higher incomes are clustered in inner suburbs and suburbs with desirable natural attributes such as beaches, trees and hills.

In Sydney, the highest median incomes are found in inner, northern and harbourside and beachside suburbs, while the lowest median incomes are concentrated in western and south-western suburbs more distant from the CBD.

In Melbourne, the highest median incomes are found in inner, eastern and bayside suburbs, while the lowest median incomes are concentrated in more distant western, northern and south-eastern suburbs.

A map also shows a clear pattern in house prices. "The premium placed on proximity to the city centre is evident in steep house-price gradients in Sydney, Melbourne, Brisbane and Perth," they say.

Research by the Reserve Bank shows that, if you rank house prices for any of those cities according to their distance from the central business district, you get an almost perfect curve that (using figures from 2010) starts well above $1 million in Melbourne and Sydney and then declines steadily to about $300,000 when you're more than 60 kilometres from the centre.

This relationship between proximity and house prices has strengthened in recent decades, with average annual growth in house prices about 2 per cent higher in inner suburbs within five kilometres of the centre than on city fringes.

Those people out in the boondocks have no idea how much we struggle with our mortgages - and we have no idea that they have problems too. Price of petrol, for starters.
Read more >>

Monday, August 25, 2014

Mining boom makes little sense

Conventional economic analysis assumes the behaviour of businesses is always rational but, in reality, the booms and busts that cause the ups and downs of the business cycle are driven by emotion more than rational calculation: unwarranted optimism, greed, impatience, short-sightedness and herd behaviour. Consider our resources boom.

The ideology of economic rationalism says private enterprise can do no wrong; ill-advised behaviour by business arises only through its rational response to distorted incentives created by the misguided interventions of governments.

This confers on the demands made by business a sanctity the captains of industry are quick to exploit. But their demands often aren't in the community's wider interest.

Now we're emerging from the decade-long resources boom it's easier to view the process with greater insight and make a more sober assessment of its costs and benefits.

What happened was a huge jump in the world prices of coal and iron ore as China's period of rapid economic development of heavy industry and infrastructure caused global demand to outstrip global supply.

The surge in China's demand caught the world's mining industry unprepared.

Like miners in other countries, our largely foreign-owned miners lapped up the huge increase in prices and profits.

But it didn't take long for greed ("the profit motive", if you prefer) and the irrational optimism that drives the world's entrepreneurs to take over, with companies seeking to exploit the high prices to the full by expanding their production capacity as much as possible as fast as possible.

What then kicked off was a multibillion-dollar race - between rival companies in a country, but also with the many companies in other countries, all expanding their capacity as fast as they could.

It takes a long time to build new mines and bring them into production. So the chances of your mine being completed in time to enjoy the super-high prices aren't great - the more so because it's essentially a self-defeating process: the more companies join the race and the harder they try to be among the first to complete, the sooner supply catches up with demand and prices start falling.

If mining companies were more rational, fewer would join the race. But companies are just as subject to herd behaviour as investors in a booming sharemarket. A mining chief who didn't join the comp would be subject to heavy criticism.

This is where the irrational optimism comes in. Each individual entrepreneur is in no doubt he'll be among the race's winners. We're gonna make a motza.

But while the miners are busy gearing up, their foreign customers are just as likely to be coming towards the end of their own boom in investment and construction. The inevitable result is that the global mining industry moves from a starting point of undercapacity to an end point of overcapacity.

This is the eternal story of mining. Only in passing is it ever in equilibrium; it's almost always in either under or oversupply - probably spending a lot more time over than under, the less profitable of the two conditions.

Now, this cycle isn't news to conventional economics, with its familiar "cobweb theorem" and "hog cycle" seeking to explain the phenomenon. But these models put too much of the blame on the unavoidable delays in increasing production, and too little on animal spirits.

And they don't prepare us for all the waste and inefficiency involved in a resources boom. In the miners' race to be first in and best dressed they compete furiously for resources, bidding up hugely the prices of labour, equipment and materials, and ending up with mines that cost them far too much to build.

They also develop lower-grade mineral deposits, the exploitation of which becomes uneconomic as soon as the world price drops back from its record heights.

In the aftermath of the boom, many acquisitions are written off, the chief executives who presided over these excesses get the chop and are replaced by bosses whose main skill is cost-cutting. They make speeches about how excessive Australian wages are.

Anyone who has followed the fortunes of our big three - BHP Billiton, Rio Tinto and Glencore Xstrata - will know just what I'm talking about.

In their race-driven frenzy to start new projects, the miners always portray themselves as impatient for God's will to prevail, with any politicians or community members who have doubts about allowing them to rip up the environment denounced as agents of the anti-progress devil.

In the aftermath of such booms we realise we should have refused to be rushed. Why does no economist ever warn us to be less short-sighted? Their faulty model.
Read more >>

Saturday, August 23, 2014

Many reasons for the impossible: power demand falling

We know the two great certainties in life are death and taxes, but many thought there was a third: the inexorable rise in consumption of electricity. As the population grew and each of us got a little more prosperous each year, we'd use more power. The mighty electricity industry was built on that certainty.

Except that electricity consumption has been falling for the past four years. To say this has taken the industry by surprise is an understatement. For well over a century – even during the Great Depression – the quantity of electricity used in Australia each year was greater than the year before.

It took the industry and its regulators two or three years to accept the trend was more than just a hiccup on the ever-upward path, which delay probably added to the decline.

There are few aspects of the economy – global or national – where change is more significant, more diverse or more interesting than energy supply and demand – where energy covers coal, gas (conventional and unconventional), petroleum, wind, solar and other renewables. Expect to hear more from me on the topic.

But there are few questions more interesting than exactly why the unthinkable, a fall in electricity consumption, has come about. Short answer: a surprisingly large combination of reasons, although Tony Abbott's crusading against the carbon tax must get some of the credit.

The best attempt to quantify the various factors involved comes from a report prepared by Dr Hugh Saddler, an energy expert with the Pitt and Sherry consultancy, for the Australia Institute. Saddler's modelling covers the years to 2012-13, but we know from reporting this week by Origin Energy and AGL that the fall continued in 2013-14.

Saddler focuses on energy produced and consumed from the National Energy Market, which covers the five eastern states and the ACT, but the decline is occurring also in Western Australia. After peaking in 2008-09, consumption from the national market in 2012-13 was down by almost 8 terawatt hours, or 4.3 per cent.

But that's only half the story. Just as important as why demand has fallen is why it hasn't continued growing, as continued growth in the population and the economy would lead us to expect. Saddler estimates that had demand continued growing from 2004 at its average rate of growth over the previous 20 years (2.5 per cent a year) it would have been 37 terawatt hours more than it actually was in 2012-13.

This shortfall is equal to the output of almost 5000 megawatts of coal-fired generation capacity, the combined capacity of the Bayswater and Eraring power stations in NSW, or Loy Yang A and B and Hazelwood in Victoria.

"All of the decline in consumption has been at the expense of coal-fired generators, with the result that many are now barely profitable," Saddler says.

Greenhouse gas emissions fell by 9.2 megatonnes of carbon dioxide equivalent, about 2 per cent of Australians total annual emissions.

So what has caused our power consumption to fall rather than rise? The biggest single reason is the introduction from the late 1990s of regulations to increase the energy efficiency of refrigerators, freezers and many other residential and commercial appliances, and to increase the energy efficiency of new buildings.

Saddler estimates this explains 37 per cent of the 37 terawatt-hour shortfall from what might have been.

The next biggest part of the explanation is structural change in the economy away from electricity-intensive industries. Over the year to September 2012, three major NSW industrial power users – Port Kembla steelworks, Kurri Kurri aluminium smelter and the Clyde oil refinery – were partly or completely shut down. This explains 10 per cent of the 37 terawatt-hour shortfall.

The evidence also suggests that power consumption by other major industrial users has been little changed over the three years to 2012-13. Saddler estimates that this failure to grow explains a further 14 per cent of the shortfall, taking the total contribution from structural change to almost a quarter.

The next most important part of the explanation is the response of electricity users, particularly residential users, to the higher prices they were being charged. Saddler finds that after 2010 there was "an abrupt change in consumer responsiveness to higher prices".

This was the time when the possible effect of a carbon tax on electricity became a major political issue thanks to the efforts of Abbott and his "sceptic" mates. At the time, retail electricity prices were rising spectacularly, mainly because of a huge increase in spending on upgrading the transmission and distribution networks (poles and wires) to cope with an expected ever-rising peak demand on hot summer afternoons.

Saddler finds evidence to support his argument that all this carbon-tax-related fuss about the high cost of electricity caused many households to be a lot more conscious of what was happening to their power bills and to respond by finding ways to cut their usage – to the extent that they "have managed to completely offset the effect of higher prices on their household budgets by reducing consumption".

This highly unusual jump in the short-run "price elasticity" of electricity explains 19 per cent of the shortfall, he estimates.

He further calculates that the growth in output from rooftop photovoltaic solar and other small, distributed generators accounts for about 13 per cent of the shortfall. This, of course, is a fall in the demand for electricity supplied by the major, mainly coal-fired generators, not a fall in the use of electricity as such.

Saddler notes that for the past three years the annual peak demand has been falling, not increasing, despite the huge investment to cope with ever-rising peaks. When will this additional capacity, which is now built and for which all electricity consumers are paying – and will continue to pay for some years to come – be required, if ever, he asks.

Good question.

Read more >>

Wednesday, August 20, 2014

Abbott's economic script is out of date

It doesn't seem yet to have dawned on Tony Abbott that he was elected because he wasn't Julia Gillard or Kevin Rudd, not because voters thought it was time we made a lurch to the Right.

The man who imagines he has a "mandate" to mistreat the children of boat people, ensure free speech for bigots, give top appointments to big business mates and reintroduce knights and dames, represented himself as a harmless populist before the election.

The other thing he doesn't seem to have realised is that just as he has us moving to reduce our commitment to action against climate change and to make the budget much less fair, the rest of the advanced economies are moving the opposite way.

President Obama is taking steps to overcome Congress's refusal to act on global warming, the Chinese get more concerned about it as each month passes and the International Monetary Fund is chastising us for our apostasy.

And while we use our budget to widen the gap between rich and poor, people in other countries are realising the need to narrow it.

Wayne Swan, former Labor treasurer, noted in a speech on Monday that "centre-right political leaders across the globe are acknowledging the obvious truth that capitalism is facing an existential challenge ... only last week ratings agency Standard and Poor's emphasised yet again that high inequality is a drag on growth".

In Australia, however, an increasing "vocal minority has decided to oppose any reform, no matter how necessary and no matter how obvious in its benefits to the whole nation, if they perceive it is in their short-term interests to do so".

"This is a recipe for unnecessary political division and widening social inequality, and unfortunately permanent reform failure," he says.

Australians had done much better than the Americans at matching strong economic growth with social equity but, according to Swan, "we're witnessing the Americanisation of the Right in this country. Obsessed with defending the advantages of the wealthiest in our society".

In his efforts to defend rather than correct his first budget's unfairness, Joe Hockey seems to be doing just that. Meanwhile, the messages from international authorities are very different.

In a recent paper on policy challenges for the next 50 years, the Organisation for Economic Co-operation and Development warned the growing importance of skill-biased technological progress and the rising demand for skills, will continue to widen the gap between high and low wages.

Unless this was corrected by greater redistribution of income, other OECD countries would end up facing almost the same level of inequality as seen in the US today. "Rising inequalities may backlash on growth, notably if they reduce economic opportunities available to low-income talented individuals," it warns.

Christine Lagarde, managing director of the International Monetary Fund, noted in a speech that the 85 richest people in the world control as much wealth as the poorest half of the global population - 3.5 billion people.

"With facts like these, it is no wonder that rising inequality has risen to the top of the agenda - not only among groups normally focused on social justice, but also increasingly among politicians, central bankers and business leaders," she said.

"Many would argue, however, that we should ultimately care about equality of opportunity, not equality of outcome." As it happens, Hockey has defended his budget's unfairness with just that argument.

"The problem is that opportunities are not equal. Money will always buy better-quality education and health care, for example. But due to current levels of inequality, too many people in too many countries have only the most basic access to these services, if at all. The evidence also shows that social mobility is more stunted in less equal societies."

Disparity also brings division. "The principles of solidarity and reciprocity that bind societies together are more likely to erode in excessively unequal societies. History also teaches us that democracy begins to fray at the edges once political battles separate the haves against the have-nots."

Pope Francis put this in stark terms when he called increasing inequality "the root of social evil".

"It is therefore not surprising that IMF research - which looked at 173 countries over the past 50 years - found that more unequal countries tend to have lower and less durable economic growth," Legarde said.

Get that? Until now, the conventional wisdom among economists has been that efforts to reduce inequality come at the expense of economic growth. Now a pillar of economic orthodoxy, the IMF, has found it works the other way round: rising inequality seems to lead to slower growth.

Lagarde said other IMF research had found that, in general, budgetary policies had a good record of reducing social disparities. Social security benefits and income taxes "have been able to reduce inequality by about a third, on average, among the advanced economies".

What can we do? "Some potentially beneficial options can include making income tax systems more progressive without being excessive; making greater use of property taxes; expanding access to education and health; and relying more on active labour market programs and in-work social benefits."

Perhaps in his efforts to get a modified version of his budget passed by the Senate, Hockey could bring in the IMF as consultants.
Read more >>

Monday, August 18, 2014

Stop wasting money on infrastructure

Don't laugh too hard at the ABC's new satire, Utopia, and the wasteful and appearances-driven antics Rob Sitch gets up to as head of the Nation Building Authority. It's too close to the truth to be funny.

One of the foremost areas where governments need to lift the efficiency of their spending - as opposed to cutting payments to the needy or short-sighted cost-shifting - is infrastructure. It has become an area where too much spending is never enough and anything labelled "infrastructure" is above critical scrutiny.

In recent days, however, we've been given cause to cast a more sceptical eye over spending on capital works. Consider first the views of a highly experienced former econocrat, Dr Mike Keating: "Australia has a long history of over-investment in infrastructure, with the costs exceeding the benefits, and under-charging the beneficiaries so that they demand more and more.

"It is therefore most reprehensible that this budget prides itself that new spending decisions will add $58 billion to total infrastructure investment, when none of the projects announced have been ticked off by Infrastructure Australia as having completed proper cost-benefit appraisals, probably because a great deal of this investment never could pass any proper evaluation.

"And this from a government that was properly critical of the former government and its approach to the national broadband network. Clearly this improper use of the nation's savings is not an acceptable reason for the other budget cuts, and the increase in petrol excise should not be tied to an increase in uneconomic road funding."

Yes, indeed. It's disillusioning behaviour from Tony Abbott, who promised "rigorous, published, cost-benefit analysis" of infrastructure projects.

Last week, Garry Bowditch, chief executive of the University of Wollongong's SMART infrastructure facility, offered a sobering assessment of capital works spending, noting that cost overruns have reached between $4 billion and $5 billion a year.

Value for money is thrown out the window, he said, when governments fail to time the construction of infrastructure to make sure they're not inflating the prices of labour, materials and equipment by competing with the private sector during booms.

Adjusted for inflation, Brisbane's Gateway Bridge, built in 1986, cost about $300 million. But when a second, identical bridge was built in 2010, during the mining construction boom, it cost $1.7 billion.

Bowditch, a former econocrat, called on governments to release cost-benefit analyses for Sydney's proposed $11.5 billion WestConnex motorway and Melbourne's $8 billion East West Link tunnel.

He argued that poor long-term planning by federal and state governments, which don't communicate well with each other, had led to unnecessary costly construction methods, such as tunnels, because land corridors had not been reserved for rail and road development.

Sir John Armitt, former chairman of Britain's Olympic Delivery Authority, said we should be using technology to improve the capacity of existing rail, road and energy networks, and to prepare for driverless cars.

Good point. Politicians love cutting ribbons and announcing grand, nation-building projects. But they'd waste less taxpayers' money if they got the pricing of existing infrastructure right first, and so had a more realistic estimate of the demand for additional infrastructure. It's called efficiency.

The credibility of economic modelling by allegedly independent consultants is surely shrinking before our eyes. Not long ago we were treated to the spectacle of two leading firms of economic consultants producing diametrically opposed modelling of the cost of the renewable energy target. Why? Surely not because they were commissioned by outfits with rival axes to grind?

Last week we learnt that AMP, whose funds lost a lot of dough after the failure of the outfit owning Sydney's Lane Cove Tunnel in 2007, is suing the consultants who provided excessive forecasts of the likely traffic flows, accusing them of producing figures that were "reverse engineered" by working backward from their client's commercial objective. Surely not.

One reason it would be good to see cost-benefit analyses of the aforementioned infrastructure projects adopted by the Coalition is to test the efficiency of Abbott's insistence that he'll finance roads but not public transport.

So far the NSW and Victorian governments have done a hopeless job of limiting congestion. Since building extra motorways adds to demand rather than reducing delays, my guess is neglect of public transport is the culprit.

But the Grattan Institute's report on cities as engines of prosperity reminds us that the longer it takes people to move between home and job, the harder it is to fully exploit the "knowledge spillovers" that drive the knowledge economy. Didn't you guys say you were worried about slow productivity improvement?
Read more >>

Saturday, August 16, 2014

Economists should learn some geography

One of the great failings of economists is their confident assumption that their way of looking at the economy is the only way - certainly, the only useful way - of understanding it.

For one thing, their almost exclusive focus on money - prices, actually - and their convenient assumption that people are rational, allows them to analyse an economy populated by automatons rather than fallible, flighty humans.

Behavioural economics and economic sociology attempt to correct this deficiency.

But there's another way of studying the economy that most economists take little interest in, to the detriment of their understanding of how the economy ticks: its spatial dimension. This failure is getting more costly as we move to a knowledge economy.

Why isn't economic activity spread pretty much evenly across our vast continent? Why is almost all of it concentrated around our coastline?

For most of our states, up to three-quarters of their economic activity is concentrated in their capital city, which is also the state's first site of white settlement. This is partly an accident of history. Newcomers tend to settle where other people are already settled.

But economic geographers have long known there's also a lot of economic logic to where people settle. Farmers tend to settle where the most arable land is. Mines have to be built where the minerals are.

Manufacturers have to decide whether to build their factories close to where their raw materials are or close to where their customers are. They usually decide to set up in cities, often on the outskirts of cities where land is cheaper.

What's more, many of the firms in a particular industry will gravitate to the same city, usually a big one. Why? So as to exploit "economies of agglomeration".

You've heard of economies of scale. Economies arise when similar firms agglomerate (cluster together). Workers with skills relevant to that industry are attracted to that city, meaning firms have less trouble getting the skilled workers they need. Workers who lose their jobs at one firm may not need to move house to get another job at a similar firm.

Likewise, the manufacturers and their suppliers of specialist equipment and materials each benefit by being close to each other. Firms in the same business can keep an eye on each other, copying anyone who gets on to a better way of doing things. That way, the whole industry gets more efficient at a faster rate.

All this has long been understood by economic geographers. But the advent of the knowledge economy has given agglomeration economies a major new twist and added to the economic significance of big cities, as the report, Mapping Australia's Economy: cities as engines of prosperity, by Jane-Frances Kelly and Paul Donegan, of the Grattan Institute, has pointed out.

"Today the Australian economy is no longer driven by what we make - the extraction and production of physical goods - but rather by what we know and do. Like other advanced economies around the world, our economy is continuing to become more knowledge-intensive, more specialised and more globally connected," the report says.

"Knowledge-intensive businesses - which are the most productive today - tend to cluster and thrive in the centres of large cities."

It turns out economic activity in Australia is concentrated in and around large cities, but is not distributed evenly within cities. Central business districts and inner-city areas are especially important: they represent substantial concentrations of employment, but even more intense concentrations of economic activity. In other words, CBD workers have a lot higher productivity than other workers.

The report explains that "the more highly skilled and specialised a job, the greater the need to find the best person to fill it. This is especially important when the work involves knowledge, expertise, judgment and learning".

Being close to suppliers, customers and rivals helps businesses generate new business opportunities and ideas for products and services, and better ways of working. These transfers of expertise, new ideas and process improvements that occur through interactions between businesses are called "knowledge spillovers" (a class of "positive externality").

Within cities, CBDs and inner-city areas offer the most opportunities for face-to-face contact among workers, essential to benefiting from knowledge spillovers. Spillovers often involve combining and recombining knowledge to come up with new products and ways of working.

Workers build on each other's thoughts, jointly solve problems and break through impasses. Trust is essential, and these kinds of complex conversations are best had in person.

"High-speed broadband and other advances in communication technologies will never replace the importance of face-to-face contact," we're told.

Grattan's research finds that residential patterns and transport systems mean CBD employers have access to only a limited proportion of workers in metropolitan areas. Turning that around, many workers, particularly in outer suburbs, have access to only a small proportion of jobs across the city.

For instance, in some outer suburban growth areas of Melbourne, just 10 per cent of the city's jobs can be reached within a 45-minute drive. If work journeys are made by public transport it's worse.

The report warns that, unless governments lift their game, "Australian cities are likely to continue to spread outwards, further increasing the distance between where many people live and the most productive parts of large cities". This would harm productivity - and workers' opportunity to get ahead.

The point is, governments need to understand the economy's spatial dimension and respond by ensuring transport networks better connect employees with employers, and businesses with their customers and suppliers. Continue letting congestion worsen and you cause productivity to be lower than otherwise, not to mention adding misery to people's lives.
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Wednesday, August 13, 2014

Big business now calling the economic shots

Sometimes I wonder whether the economy is being managed for our benefit or for the benefit of the big businesses that dominate it. The two big supermarket chains we get to choose between, the two domestic airlines and privately owned airports, the three foreign mining giants that were allowed to redesign the mining tax they didn't like, and the four big banks that control so much of our superannuation and the investment advice we get, not to mention our savings accounts and mortgages.

I'm old enough to remember when economic life seemed to be dominated by big unions. Hardly a month passed without our lives being disrupted by some strike. We'd be walking miles to work or finding someone to mind the kids while the teachers were out.

I remember finishing a holiday in New Zealand with our young family, only to find the baggage handlers in Sydney were on strike and being stuck in Christchurch for an extra two days.

Thank goodness we don't have to put up with all that any more. But in place of being bossed around by the unions, we now have big business calling the shots. They don't inconvenience us like the unions did, but they do seem to have the ear of government.

Big business is always complaining about some way the economy's being run that doesn't meet with its approval. It's always warning of the terrible economic price we'll pay if it doesn't get what it wants. Its complaints are always treated with reverence by the media. And always taken seriously by the government, Labor or Coalition.

We seem to be developing a new economic religion that what's good for big business is good for the country. No one believes this more fervently than the big business people themselves - plus their never-silent lobby groups.

These paragons of industry want to be unfettered in their efforts to expand their businesses and make higher profits, which they're doing purely in the interests of you and me. And they're always terribly impatient. They want to frack wherever they want to frack, they want to start tomorrow and they don't want selfish, short-sighted people to slow them down, let alone stop them.

They want to invest in a new mine or a new something which will create tens of thousands of new jobs in the district, and what other consideration could possibly trump that? If you want to consult the locals before granting permission, this is "red tape", which by definition is bad and must be swept aside. If you want time to investigate the environmental impact of the project, this is "green tape" and just as much economic vandalism as the red.

Another problem is the breakdown of "caveat emptor" - it's the buyer's job to make sure they're not ripped off. Products, particularly financial products, have become complex and hard to compare - deliberately so, you have to suspect.

In theory, we're supposed to read every word of the contracts we sign, know whether the nice man giving us advice on our savings is being paid to push some products but not others, know whether he'll go on receiving a commission for years without contacting us again, check continually to see whether our bank is now offering a better deal than we get without telling us or whether we should be moving our banking business, check what fees we're being charged on our superannuation and whether a different fund would give us a better deal.

In theory, we should devote much of our free time to doing all that. In practice, few do. We like to relax when we're not working and are diverted by an ever-multiplying range of commercial entertainments.

In practice, big business knows far more about this stuff than we do. So we need governments to protect us from being exploited, prohibiting certain kinds of behaviour, requiring financial institutions to keep us informed in ways we can understand and not take advantage of our inferior knowledge and inertia.

After many people lost their savings during the financial crisis, the previous federal government decided to tighten up on financial advice. Its original plans were modified after lobbying by the banks and their lobby groups, and now they've been watered down further by the present government - all in the name of reducing red tape.

The government compels most employees to contribute 9.5 per cent of their salaries to superannuation, from which the people running those funds extract very high fees - now equal to an amazing 1 per cent of gross domestic product - which greatly reduce final payouts.

The interim report of the inquiry into the financial system found that the fees appeared high by international standards. It found little evidence of strong fee-based competition between funds. The funds have got a lot bigger in recent years, but these economies of scale haven't led to lower fees.

The previous government introduced a new, simpler super account called MySuper in an effort to reduce fees, but the report says it's too early to assess its success in doing so. Last week, the Financial Services Council lobby group began arguing strongly that fees aren't too high. We must hope it isn't as influential in resisting the push for lower super fees as it was in getting the investment-advice protections watered down.
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Monday, August 11, 2014

Econocrats advise false economy

Joe Hockey and Tony Abbott shouldn't take all the blame for the low quality of the measures in the budget. I suspect they're victims of poor advice from the econocrats of Treasury and Finance.

Gary Banks, former boss of the Productivity Commission, says the public service's role is to inform policy choices. If so, it did an unimpressive job of informing an inexperienced government on the best way to exploit the unique political opportunity offered by the Coalition's very first budget.

We can never know exactly what advice passed between the bureaucrats and their masters, but it would be an unusual budget whose measures didn't arise from options provided by the presumed experts.

And a comment by Laura Tingle of The Australian Financial Review offers a clue: "Former Labor ministers were genuinely surprised after the May 13 budget that the new government had simply picked up the same raw policy proposals the public service had been serving up for years and included them in the budget ... It seemed no one in the new government ... recognised these as policy chestnuts from the bureaucracy's bottom drawer."

If that's right, it's an indictment of the bureaucrats' intellectual laziness and lack of expertise. It's the 21st century, but these people have sat for decades learning nothing but "here's where you could cut, minister".

A huge proportion of the spending on two of the nation's biggest and fastest-growing industries, education and health - industries whose performance has major implications for productivity and social wellbeing - passes through the federal budget, but all the budget bureaucrats have to offer is a list of things you could chop.

Since the budget measures focused almost exclusively on the spending side, and since those measures had the smell of the bookkeeper rather than the economist (economists are trained to think about subsequent, not just immediate, effects), I suspect it's Finance more than Treasury that's responsible for such a dismal performance.

What we needed were sophisticated initiatives aimed at raising the efficiency with which public services are delivered to the public.

What does the empirical literature and the experience of other governments tell us about what works and what doesn't? If Finance and Treasury aren't expert on this, why aren't they?

What we got instead were crude spending cuts - or, more often, cost-shifting. A high proportion of the savings will come merely from shunting more of the cost of education and health onto graduates, patients and the states. How much thought went into cooking that up?

The right answer to the growing cost of the Pharmaceutical Benefits Scheme, for instance, is to drive harder bargains on generics with the big foreign drug companies (which pose as Medicines Australia) and the chemists, and to force harder choices on the medicos who advise on which new drugs should be listed by giving them an annual spending cap.

So what did we get? A $5-a-pop increase in the already high general patient co-payment which, in any case, is indexed, with a smaller rise for pensioners. Could laying it on so thick discourage people from filling their prescriptions, thus worsening their health and eventually adding to public spending on healthcare?

Who knows? Who cares? No one in the budget bureaucracy, it seems. If the measure makes things worse rather than better, worry about that in a later budget. "I know, minister, let's whack up patient co-payments again. Tell 'em health costs are unsustainable."

It's a similar story with Medicare. Health economists have devised various ways of achieving greater efficiency, particularly in hospitals, but who's bothered about that? Why tax your brains when you could just chop spending on preventive health programs, slash grants to the states and introduce a $7 co-payment for GP visits and tests?

The co-payment will shift costs to the states and add to ill health and costs down the track, but who's worried? It will be costly to administer, but less so when we advise ministers to whack it up again in a few years' time because health costs are still rising "unsustainably".

But the most mindless false economy is surely the now 2.5 per cent annual "efficiency dividend" cut imposed on the budgets of government departments. Treasury complains it's had to cut staff numbers by one-third just since 2011. Finance must be suffering, too.

Wouldn't it be ironic if the budget bureaucrats were among the chief victims of their failure to give the pollies better advice on spending control? By now, of course, this would be their chief excuse for continuing bad advice. "We don't have the resources, minister."
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Saturday, August 9, 2014

Teenagers suffering most from slow growth

I hate to say it, but the spectacular events that hit the headlines aren't necessarily the things most worth worrying about. The big news on the economy this week was the spectacular jump in the unemployment rate from 6 per cent to 6.4 per just during July. Not a big worry.

Question is, what does it prove? That the economy fell into a hole around the middle of the year? Doubt it. There's little other evidence that it did and a lot that it didn't.

That the slow upward creep in unemployment we've been seeing for about two years may have accelerated? Doubt that, too. Again, the other economic indicators aren't pointing that way.

(Indeed, some economists have been wondering if unemployment was close to peaking. So far this year employment has grown by an average of 15,600 jobs a month, compared with just 5100 a month last year.)

That the unemployment figures are volatile from month to month and this is an unexplained statistical blip that should be corrected next month? Seems a bit too big for that.

Truth is it's hard to know what the problem is. Easier to be sure when we've seen another month or two's figures.

But my guess is it's a once-only upward step in the measured rate of unemployment, caused by a seemingly small change in the questions that people in the Bureau of Statistics' monthly survey are asked so as to ascertain whether they've been "actively" seeking a job if they don't have one.

The change - made partly because of the switch to searching for jobs on the internet rather than at Centrelink - seems to have led to more people being classed as unemployed and fewer as "not in the labour force".

If this guess proves right, it's not so worrying. It doesn't change reality, just the way we measure it. In any case, we've long known that the official measure of unemployment is very narrow and understates the extent of the problem.

That's why the bureau publishes every quarter a broader measure of unemployment, which takes the official unemployment rate and adds the under-employed - people with jobs who aren't working as many hours a week as they'd like to - to give the "labour force underutilisation rate".

The figures for May show narrowly measured unemployment of 6 per cent, and an underemployment rate of 7.5 per cent, to give a broader measure of 13.5 per cent.

Less spectacular than this month's jump in the official rate but, to me, more worthy of worry is news that hasn't hit the headlines: the rapid worsening in teenage unemployment.

Whereas so far this year the trend rate of overall unemployment has risen by 0.2 percentage points, the trend rate for people aged 15 to 19 has risen by 2.8 percentage points to 19.3 per cent.

Note, this doesn't mean almost one youth in five is unemployed. Most people that age are in full-time education, so aren't in the calculation. Turns out about one in 20 of all 15 to 19 year-olds is unemployed and looking for a full-time job.

Many people have it in their heads that unemployment rises because people lose their jobs and employment falls. That's true only in recessions. It's rare for employment to fall - it fell only briefly even during the global financial crisis.

No, the main reason unemployment rises outside of recessions is that the economy isn't growing fast enough to employ all the extra people joining the labour force from education, as immigrants or as mothers rejoining.

That's what's been happening over the past two years. And young people - particularly those who leave school or training too early - have borne most of the burden of insufficient job creation. We should be doing much better by them than Work for the Dole and denying them benefits for six months to keep them hungry.

But there's nothing spectacular about this quiet suffering, so it doesn't hit the headlines. Much better to scandalise over factory closures, which surely signal the end of the world. So let's look at the facts on retrenchment, courtesy of a Bureau of Statistics study.

About 2 million people left their jobs over the year to February 2013 (the latest period for which figures are available). About 60 per cent of these left voluntarily and 21 per cent left because of their illness or injury, leaving 19 per cent - 380,000 - who left because they were retrenched.

That's a rate of retrenchment of 3.1 per cent. The rate hit 4 per cent in 2000, but then fell to a low of 2 per cent in 2008, just before the global financial crisis, then increased sharply to 3.1 per cent in 2010, where it has pretty much stayed since.

Over the year to 2013, all industries experienced retrenchments, but the most were in construction, 65,000; retailing, 40,000; and manufacturing, just under 40,000.

But the number of people employed in particular industries differs a lot so, judged by rate of retrenchment, utilities and construction come equal first with 6.4 per cent, then mining with 6 per cent, pushing manufacturing into fourth place with 4.5 per cent.

The rate of retrenchment is consistently higher for men because men tend to dominate those industries where retrenchment rates are higher, whereas retrenchment rates tend to be lower in industries dominated by women workers, such as education and health.

The likelihood of being retrenched falls as your level of educational attainment rises. We're more conscious of older workers being laid off but, in fact, retrenchment is greatest among workers aged 25 to 44.

And what happens to people who're laid off? For those retrenched over the year to February 2013, half were back in jobs by the end of the year, leaving 29 per cent unemployed and 21 per cent not in the labour force.
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Wednesday, August 6, 2014

Modellers bamboozle over cost of renewable energy

There's a lot of public support for the renewable energy target, which requires electricity retailers to get 20 per cent of their power from renewable sources by 2020. But now the country's being run by climate change "sceptics", let's get with the program. Forget the threat of climate change, stop worrying about your grandchildren and focus on what matters most: what this do-gooder scheme is doing to your cost of living.

Although before the election Tony Abbott professed support for the target, since the election he has instituted an expert review of it, headed by businessman Dick Warburton, former chairman of Caltex and prominent "sceptic".

The review commissioned a leading firm of economic consultants, ACIL Allen, to undertake modelling on the future effects of the target.

The preliminary report found that, between 2015 and 2020, the target would increase the average household electricity bill by $54 a year - a tad over $1 a week. This five-year average, however, conceals the estimation that the cost of the scheme will fall as each year passes.

So by 2020 itself, the increase will have reduced to just $7 a year. By the end of another 10 years, in 2030, the scheme is estimated to be actually reducing average household electricity bills by $91 a year, or $1.75 a week.

It's common sense that requiring electricity retailers to buy a certain proportion of their power from more expensive renewable sources - mainly wind power, but also solar - would add to the cost of their power, with the extra cost being passed on to consumers.

So why has ACIL Allen's modelling concluded the target will add to the price of electricity initially, but eventually subtract from it? The short answer is because electricity pricing is a complicated business.

It turns out that adding to the supply of renewable energy available reduces the wholesale price of electricity. This is because the price being paid for energy being put into the national electricity grid by particular generators varies minute by minute according to the balance of supply and demand.

In the middle of the night, when little power is being used, the wholesale price is very low. But on a cold evening - or, more likely these days, a very hot afternoon - the wholesale price can be stratospheric.

The trick to renewable energy is that it tends to be available when the demand for electricity is high. Experience around the world confirms the Australian experience that renewable energy does a great job of reducing spikes in wholesale prices on very hot and very cold days.

Another part of it is that though it costs a lot to build wind and solar generators, once they're built there are few "variable" costs. Wind and sun are free; coal and gas aren't. So the renewable generators offer to supply power to the grid at very low prices and this lowers the prices the coal and gas generators are able to ask for.

But none of this changes the fact that the electricity retailers have to pay for the "renewable energy certificates" that the target scheme requires them to buy. These certificates reduce the capital cost of setting up the wind and solar generators whose operations then reduce the wholesale cost of power.

So it turns out the renewable energy target scheme has the effect of reducing the wholesale cost of electricity while also adding to the costs of the electricity retailers. ACIL Allen's modelling suggests that, for the next five years, the extra retail cost will exceed the saving in wholesale costs, but after that the saving will exceed the extra cost.

See what this means? The case for saying we must get rid of the renewable energy scheme because it's adding too much to the living costs of struggling families has collapsed.

But there's where the story takes a twist. Modelling of the future cost of the renewable energy target, published by an equally prominent firm of economic consultants, Deloitte, comes to opposite conclusions.

Deloitte's modelling accepts that the renewable energy scheme is reducing wholesale costs, and roughly confirms ACIL Allen's finding about the higher cost to household customers until 2020. But whereas ACIL Allen expects the scheme to start reducing household costs after that, Deloitte expects the cost to stay positive until 2030, causing household bills to be between $47 and $65 a year higher than if the scheme was scrapped.

Why have two leading economic consultants reached such opposing conclusions? Perhaps because Deloitte's modelling was commissioned by the Chamber of Commerce and Industry, the Business Council and the Minerals Council.

Deloitte doesn't conceal that its modelling is in reply to ACIL Allen's. Would it surprise you if the fossil fuel industry wanted to see the renewable energy target abolished and was alarmed to know that modelling commissioned by the review had demolished the argument that continuing the target would add to people's electricity bills? Now the review will be able to pick whichever modelling results it prefers.

How did Deloitte reach such different results? By feeding different assumptions into its model. It seems to have assumed the cost of wind farms won't fall over time (which it probably will), whereas the price of gas for gas-fired generators won't rise much (which it already has).

Regrettably, economic modelling has degenerated into a device for bamboozling the public.
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