Sunday, August 22, 2010

The deficit we really should worry about

The biggest and most worrying deficit in this election campaign has been the policy deficit: the reluctance of both sides to debate any aspect of economic management bar the budget.

What has passed for economic debate has proceeded from the proposition that the federal budget equals the economy. So let's see if we can get through a discussion of our economic policy challenges without further mention of that instrument.

The most obvious disappointment about this campaign is both sides are pledging to do nothing serious in the coming three years about the greatest and most pressing threat to the economy: climate change.

Left unchecked, climate change is likely to destroy or significantly damage much of our stock of private and public physical capital. To avoid the small cost of growth forgone as we tackle the problem, we're willing to risk incurring much greater losses.

Because of both sides' unwillingness to impose on voters unpleasantness roughly akin to the introduction of the goods and services tax, they're willing to waste taxpayers' money on ineffective incentive schemes while also causing the cost of eventual action to be higher than it need be. (That's assuming we wake up before we reach the point where the damage has become irreversible.)

At a more conventional level, the glaring need neither side seems to have noticed, much less wanted to do anything about, is what could be called our productivity deficit: after perking up mightily in the 1990s, our rate of productivity improvement - measured as output per hour of labour - slumped throughout the noughties.

What should we be doing to lift our productivity performance? That's what we should have been debating over the past five weeks. Failing that, it's a question we should be setting our minds to during the coming parliamentary term.

One reason we haven't had more soul-searching over the productivity deficit is that its adverse effect on our rate of economic growth - and continually rising material living standard - has been offset by the resources boom.

National income has been growing strongly because the world has been paying so much more for our coal and iron ore and because investment in new mines and facilities has been so strong. This looks likely to continue for some years yet.

But with this easy prosperity come two challenges: cyclical and structural. The mildness of the recession means we're already close to full employment, so it may not be long before the Reserve Bank is struggling to control a booming economy with interest-rate rises.

Neither public nor politicians has any real understanding of the way being at full employment constrains our ability to press ahead with every job-creating project we dream up. We're locked in a deficient-demand world view.

The structural problem has two elements: worrying about the perceived Dutch Disease problem (the temporarily high exchange rate wipes out other export industries, particularly manufacturing and tourism, so we're left with a vacuum when the resources boom ends) and deciding how to ensure we gain some lasting benefit from all the extra revenue flowing into government coffers.

If we're not careful we could end up with the same disastrous solution to both problems: pumping a lot of taxpayers' money into propping up declining manufacturing industries in the name of "value-adding". Their weak performance in this campaign suggests both sides are capable of such madness.

Our non-mining future lies in high-value services, not manufacturing, so the right answer is to increase our public (and private) investment in education, training and research. All such investment should raise our productivity in due course.

We all know our present social and economic infrastructure leaves much to be desired. We'll need to put a lot more money into it but this campaign's obsession with that thing I promised not to mention again suggests that, whoever wins, we won't be spending (and thus borrowing) as much as we need to.

Infrastructure investment adds to demand in the short term but also adds to supply (production capacity) in the medium term and productivity improvement (output per unit of input) in the longer term.

So, remembering our full-employment constraint, a great challenge facing the economic managers will be to (temporarily) constrain consumer spending to make room for more business investment and public infrastructure spending.

How? Good question. Maybe we could speed up the phased increase in compulsory superannuation saving.

Remember, however, that part of the solution to inadequate infrastructure is to use the existing infrastructure more efficiently. That means better pricing of it (with the net proceeds from that pricing also helping to fund additional investment). But better pricing requires a little political courage, something neither side has displayed in this campaign.

One area where supply-side reform is urgently needed is housing, where housing construction has fallen well behind the formation of additional households, forcing up house prices and rents. We need to remove the state and local governments' obstructions to medium-density housing and the release of serviced land.

The issue of population growth and immigration was raised in the campaign but not properly debated because both sides were just using it to dog-whistle about boat people.

The unthinking advocates of high immigration need to understand it makes a negative contribution to productivity improvement (by worsening the ratio of physical capital to labour) and demands increased investment in business equipment, housing and public infrastructure.

Unless the goal is growth for its own sake, it's a dumb way to go about raising material living standards (except those of the immigrants). It also greatly increases our difficulty in achieving targets for the reduction of our emissions of greenhouse gases.

It's all very well for the advocates of high immigration to say the underlying problem is one of inadequate infrastructure, not immigration as such. What do they propose to do about it - abolish the states? Who will pay for the extra infrastructure (on top of the existing backlog) and how will it be financed? By privately issued, but heavily publicly subsidised (and at least implicitly government-guaranteed) infrastructure bonds? That'll fix it. Not.

We do need to undertake a careful, evidence-based examination of what is a "sustainable" population, in which the economists, technological optimists and natural scientists box it out. All sides need to confront the elements of truth in the other sides' positions.

All this is what Julia Gillard and Tony Abbott should have debated over the past five weeks, but didn't. Whoever wins, the economy will lose.