Tuesday, September 18, 2007


September 18, 2007

The rationale for microeconomic reform

The fundamental objective of microeconomic reform is to improve the economy’s technical, allocative and dynamic efficiency and thereby raise our material standard of living. In distinction to conventional macro management – which focuses on stabilising demand over the short term – microeconomic policy focuses on improving the supply (production) side of the economy over the medium to longer term.

The mechanism for micro reform

The basic mechanism of microeconomic reform is to reduce government intervention in product and factor markets (the capital or financial market and the labour market) in ways designed to increase the degree of competition in those markets. Increased competition in markets should increase the pressure on firms both to raise their technical efficiency and to pass the fruits of that higher productivity on to their customers in the form of better service or lower prices. Combined with prices that better reflect the true ‘resource costs’ of producing goods and services, this should improve the efficiency of the allocation of resources within the economy, thereby causing a higher trend rate of economic growth and thus higher material living standards.

Dynamic efficiency

Dynamic efficiency refers to the economy’s ability to adjust over time in response to changing circumstances. A dynamic economy is adaptable, responsive and flexible. It is able to cope with external or domestic economic shocks to supply or demand without generating either too much inflation or too much unemployment. Our economy’s ability to sail through the Asian crisis of 1997-98 – assisted greatly by the dollar’s depreciation when demand for our exports fell off – convinced many economists that micro reform had made our economy a lot more flexible than it had been.

And, as part of this, our lasting return to low inflation has shown the economy to be much less ‘inflation-prone’ than it had been. Intensified competition in so many markets has greatly reduced the scope for firms to exercise pricing power, for importers to pass on imported inflation and for unions to negotiate excessive, ‘sweetheart’ wage deals. In short, we now have much less problem with ‘cost-push’ inflation. Another part of this is that the move to enterprise bargaining and away from centralised wage fixing has greatly reduced the scope for big pay rises in one area to ‘flow on’ to workers in other areas. This would have helped to lower our NAIRU – the ‘non-accelerating-inflation’ rate of unemployment - thereby permitting the unemployment rate to go lower without igniting wage-inflation problems.

The economy’s greater dynamism and ability ‘roll with the punches’, this has made it less unstable and thus made the macro managers’ job of stabilising the economy as it moves through the business cycle a lot easier – a major, but largely unexpected benefit from micro reform.

Key microeconomic reforms

We can list eight key areas of micro reform over the past two decades:

1. Capital markets. The Australian dollar was floated in December 1983 and controls over foreign exchange removed. Bank interest rates were deregulated and foreign banks licensed to operate in Australia.

2. Trade reforms. Import quotas – mainly for motor vehicles and textiles, clothing at footwear – were removed in the late 1980s and tariff protection for manufacturing and agriculture phased down. The effective rate of assistance to manufacturing fell from around 35 per cent in the early 1970s to 5 per cent by 2000.

3. Infrastructure services. Airlines, coastal shipping, telecommunications and the waterfront were partially deregulated. Government utilities – including railways, ports, electricity and water – were made more efficient and less overstaffed. Many were commercialised and corporatised; some were privatised. Government-owned banks, insurance companies, airlines and a telephone company were privatised.

4. Industry deregulation. Many industries – including stock broking, petrol distribution, eggs, bread and dairy – have been deregulated, as have shopping hours.

5. Government services. Many reforms have been introduced, including competitive tendering and contracting out, performance-based funding, the formal definition and costing of ‘community service obligations’ and user-pays pricing.

6. Labour market. The prices and incomes Accord, operating from 1983 to 1996, restructured and simplified awards and shifted from centralised wage fixing to enterprise bargaining. The Howard Government’s Workplace Relations Act of 1996 further reduced the scope of awards and introduced a formal system of individual employment contracts known as Australian Workplace Agreements. Work Choices seeks to discourage collective bargaining and unionism.

7. Taxation reform. Capital gains tax, fringe benefits tax and the dividend imputation system were introduced in 1985 and 1987, along with large cuts in income tax rates. The goods and services tax was introduced in 2000, replacing the narrow wholesale sales tax and a range of state stamp duties. The company tax rate was cut to 30 per cent.

8. National competition policy. An agreement between Paul Keating and the state premiers in 1995 had four main elements: extension of the Trade Practices Act to government businesses and the professions; reforms to public monopolies; introduction of a regime to provide other firms with access on reasonable terms to privately owned monopoly infrastructure services; and introduction of a program to review all federal and state legislation restricting competition. National competition policy has now been replaced by the National Reform Agenda.

Evidence of the benefits of micro reform

During the five years to 1998-99, labour productivity grew at the highest rate for at least 30 years. The improvement in the average productivity growth rate over this five-year period (of about 1 percentage point) provided the equivalent of an additional $7000 to the average Australian household.

This remarkably strong performance is widely attributed to the delayed effects of micro reform. In the years since then, however, our productivity performance has fallen back to normal levels. This may be because of the fall-off in further reform under the Howard Government. The poorer performance in very recent years is thought to be due partly to the surge in mining investment associated with the resources boom which, while the new production capacity is still coming on line, means the mines are employing more workers without any increase in output. This should be just a temporary factor, of course.