Saturday, March 31, 2012

We risk letting lawyers stifle innovation

If our business people, economists and politicians are genuine in their desire to lift our productivity, rather than just moan about the Fair Work Act, they'll put reform of the regulation of intellectual property high on their to-do list.

Unfortunately, the minor changes to intellectual property regulation put through Parliament last week, to the accompaniment of great self-congratulation by the Gillard government, suggest the professed true believers in productivity improvement just don't get it.

If we're really concerned to encourage invention, innovation and creativity, nothing could be more central than the way we regulate intellectual property. But I get the feeling a lot of people have lost sight of what we're doing and why we're doing it.

So let's start with the basics. When governments grant patent or copyright protection they are intervening in the market to give particular individuals or businesses a monopoly over the commercial exploitation of that idea for up to 20 years.

When you've got a monopoly you're able to charge higher prices than if you had competitors selling access to the same idea. So why on earth would a government grant such favours?

Well, the rationale is to increase the monetary incentive for people to come up with inventions, innovations and creations that benefit the community. If I dreamt up some new thing, but other people were immediately able to copy it and compete with me, I wouldn't get much reward for my effort and ingenuity.

In which case, people like me won't be trying very hard to come up with new ideas. So the government grants inventors and creators a temporary monopoly over their idea to encourage more good ideas.

The point to grasp is that this approach involves a trade-off. The government imposes a cost on the community by effectively allowing rights-holders to overcharge for their products, but it does so in return for the greater benefits this brings to the community.

This suggests, first, that governments should never grant rights or enhanced rights to individuals and firms unless it's clear the granting of those rights leaves the community better off. Second, governments should always be checking to ensure the benefits to the public from the protection of intellectual property exceed the costs to the public of that protection.

Were the public costs ever to exceed the public benefits, the entire economic justification for the artificial creation of property rights would evaporate. It would be a classic instance not of "market failure" but "government failure".

The reason reform of intellectual property should be high on the productivity promoters' to-do list is that we seem to be drifting ever closer to the point where its costs exceed its benefits. That seems particularly true in the United States - and we look to be going the same way.

The US plays a pivotal role in the globe's intellectual property. It's at the frontier of technological change and creativity, and is a net exporter of intellectual property to every country in the world. Increasingly, intellectual property, designs for new machines, pharmaceuticals, electronic gadgets, films, TV shows, books, recordings and much else, is the main thing the US sells the world.

These days, making the world a safer, more profitable place for American intellectual property is the main objective of US trade policy - as we found when we negotiated the misnamed free-trade agreement with the US in 2004. We were pressured to make our laws fit with the Americans', and we'll get more pressure to become more like them in all future trade negotiations.

So what's the problem? Much of it is that the whole area has been taken over by lawyers. It's become hellishly legalistic, complicated, loophole-ridden and expensive. In the process, the lawyers have lost sight of the economic object of the exercise. It's become an area of endless battles between businesses arguing over their rights.

The other part of it is that powerful industry groups have taken to lobbying politicians to change the law in ways that advance their interests without benefit to the public. And US businesses increasingly engage in game-playing in the hope of ripping each other off.

American pollies are often persuaded to extend the life of intellectual property protection retrospectively, which obviously does nothing to encourage innovation in the past.

The patent system has been extended to cover software (which was already copyright) and even business methods. It's too easy to get a patent - you can get them for very obvious ideas - and patents can be too broad, covering yet-unthought-of uses.

You can get a patent for something that's very similar to someone else's patent. But because they're handed out so easily, you often don't know whether a patent is valid - whether his patent beats your patent - unless you spend between $5 million and $7 million battling it out in court. The high cost of litigation means big businesses regularly intimidate small businesses.

This problem of "fuzzy boundaries" to patents is so bad some businesses make a living as 'patent trolls' buying up dodgy patents, then threatening to sue legitimate patent-holders. The victim pays what amounts to protection money to avoid the higher cost of a court battle.

You've no doubt heard of the huge patent battle between Apple and Samsung being fought in courts around the world. Which side has the legitimate patents for tablet technology?

Pharmaceutical companies use a trick called "evergreening" to stop their patents expiring, which would have allowed competition from generic drug producers to slash the prices they can get for their drugs.

The owners of intellectual property rights often attempt to use them to protect themselves from losing business to firms developing more innovative ways of doing things.

Just as undesirable, researchers trying to develop better products can be held back by the prohibitions or high costs imposed by existing patent holders (some of which may not be legit).

It's got so bad in the US that, according to the calculations of a leading academic campaigner for patent reform, James Bessen, of Boston University school of law, for all US patents bar those for chemicals and pharmaceuticals, earnings from their patents are more than exceeded by the cost of litigation to protect those patents. He calls this a "patent tax".

If he's right, the intellectual property system has degenerated to the point where it's actually inhibiting innovation. We're being forced to pay higher prices, but getting nothing in return.

Wednesday, March 28, 2012

Why most of us live in big cities

We live in the age of the city. A year or two ago we passed the point where half the world's population was now living in urban areas. This is because the rapid economic development of many large but poor countries is as much about urbanisation as industrialisation. Now experts are predicting the proportion of us living in cities will rise to 70 per cent within the next 40 years.

This isn't happening by accident. People migrate from the country to the city in the confident belief - invariably more right than wrong - this will raise their standard of living.

Putting it another way, there are huge economic advantages if most of us live in big cities, packed together like sardines. Economists call these the "economies of agglomeration".

When businesses are located close to their customers, suppliers and potential employees, they can produce their goods and services at less cost. When a number of businesses in the same industry are located in the same city there are further savings.

That's the economists' conventional explanation of why we pile into cities.

More recently, Professor Edward Glaeser, of Harvard, has argued that cities - and the face-to-face contact they make possible - are the ideal bed for germinating and propagating the ideas that drive the information economy.

So, much of the rich world's affluence is owed to our penchant for crowding together. And when politicians and economists turn their mind to cities their concern is usually to ensure the economic benefits keep rolling in.

But what about the social, psychological side? Do we pay a high social or mental price for so much unnatural crowding? As a general proposition, I'm not sure we do. Most city slickers enjoy living in cities, surrounded by so many people and so much choice.

Even so, we're engaged in a tricky balancing act, enjoying the benefits of having so many around us while retaining some personal space and privacy. In the country everyone looks after each other - or so we like to think - but in the city we tend to mind our own business.

When we get this balance wrong, city living becomes more impersonal and less satisfying than it should be. In the extreme case, there can be so much keeping-yourself-to-yourself that individuals feel lonely and isolated in the midst of the crowd.

Do economists ever worry about this sort of thing? No, not their department. Do politicians? Since they're so preoccupied with matters economic, probably not as much as they should.

These issues are explored in a new report from the Grattan Institute, Social Cities, by Jane-Frances Kelly and others. Let me summarise its findings.

It finds that social connection - our relationships with others - is critical to our wellbeing. Humans are social animals. We evolved in an environment where group membership was essential to survival, so now it's built into our brains.

We form connections at three levels: intimate personal and family relationships, links with a broader network of friends, relatives and colleagues, and collective connection - our feeling of belonging in our communities.

Social connection is important to our health as well as our happiness. Loneliness can be as bad for our health as high blood pressure, lack of exercise, obesity or smoking. Australian research shows that older people with stronger networks of friends live longer.

"The importance of social connection to health and wellbeing means that, for many people, improved relationships are a much more realistic path to a better life than increased income," the report says.

The few internationally comparable statistics relating to social connection suggest Australia is doing well. On the proportion of people who have relatives or friends they can count on in a time of need, we rank sixth out of 41 mainly developed countries. On the proportion of people who feel most other people can be trusted, we rank fifth.

Even so, our degree of social connection is declining. Our average number of friends has fallen in the past 20 years, as has the number of local people we can ask for small favours. And social connection is unevenly distributed. People on lower incomes and people with disabilities have lower trust in others.

One-person households account for a quarter of all households and are the fastest-growing type. You're not lonely just because you live alone, but the risk of it is a lot higher. Being a single parent is a risk factor, as is having limited English.

The report stresses it doesn't believe in physical determinism - that design is destiny. Even so, "the shape of our cities can make it easier, or harder, for people to interact'.

"Where we live, work and meet, and how we travel between these places, has a big impact on how much time we have to connect, and who we can meet face-to-face," it says.

Social connection is becoming more widely recognised as an important goal in the design of streets and the architecture of buildings. But when major decisions about transport infrastructure and land use are made, social connection is rarely given the same priority as the movement of people and goods for employment and commerce.

Inefficient urban transport networks see much of our day swallowed up by commuting, leaving us less time for friends and family. It's simpler for people to get together to play sport if training grounds are available nearby, and it's easier to organise a picnic if you can walk to a local park.

"If our cities are to absorb larger populations and improve quality of life for all, they will need to meet our social as well as our material needs," the report concludes.

Monday, March 26, 2012

Subsidies no way to fix high dollar problem

Emeritus Professor Max Corden, of Johns Hopkins University, formerly of Oxford University and now back at the University of Melbourne, is probably Australia's most distinguished living economist. So when he writes on what we could do about "Dutch disease" we ought to take note.

What follows is my account of his paper for the Melbourne Institute, The Dutch Disease in Australia: Policy Options for a Three-Speed Economy. As is often my custom, it will consist largely of direct quotes, indirect quotes and paraphrases of his paper. This practice is known as "reporting". If I misreport his views, feel free to criticise; but don't be silly and accuse me of stealing them.

Corden is an expert on Dutch disease - the economists' term for a situation where a boom in one export industry leads to an appreciation in the exchange rate, which reduces the profitability and the output of other export and import-competing industries.

He starts by dividing the economy into not two, but three sectors according to how they're affected by the boom. First is the "booming sector" (mining and related industries, in our case), then there's the "lagging sector", consisting of the other trade-exposed industries hard hit by the high dollar (part of manufacturing, agriculture and tradeable services such as tourism and some education).

But then there's the "non-tradeable sector" consisting mainly of those service industries whose prices are determined only by domestic supply and demand. This third sector is important because it's the largest part of the economy and "there are almost certainly net gains" from the boom.

The gains arise because the boom causes increased domestic spending on non-tradeables and because of the reduced prices of imported items.

Corden argues there are three broad options for the government to choose from in responding to the difficulties Dutch disease causes for the lagging sector.

Option 1 is "do nothing". "The real exchange rate appreciation is an inevitable consequence of the terms of trade boom and the capital inflow, both of which have benefits," Corden says.

"Some industries rise and some decline, and some declines, in any case, may be temporary. The government can help in the adjustment process, but should not try and stop or slow up adjustment," he says.

"This is one point of view, though it may not be politically attractive," he says. But "doing nothing" doesn't prevent the government from fostering the flexibility of the economy, improving the skills of the labour force, removing obstacles to people moving, temporarily assisting losers, providing information or improving infrastructure.

Option 2 is "piecemeal protectionism". "Of the various groups of industries adversely affected by Dutch disease it is manufacturing - or perhaps particular manufacturing industries, or even firms - that are usually selected for deserving special assistance, whether in the form of subsidies or import tariffs," Corden says.

But this option is "highly undesirable" and "based on questionable economic thinking". (Note that when Corden uses the term "protection" he's including subsidies as well as import tariffs.)

What's wrong with piecemeal protection? Apart from all the usual arguments against protection, there's one that applies particularly to Dutch disease, but is usually overlooked. Corden calls it the "general equilibrium effect".

"Suppose extra protection is provided for the motor car industry," he says (writing well before last week's announcement of extra assistance to General Motors). This reduces imports of cars, as is the intention of the policy, but will lead to extra appreciation of the exchange rate.

If all manufacturing industries were significantly protected there would be a substantial appreciation, which would actually worsen the Dutch disease effects on other industries in the lagging sector - agriculture, tourism and education exports.

Similarly, protection for selected manufacturing industries would have adverse effects on other industries in the lagging sector, including those parts of manufacturing that didn't receive the extra assistance.

"These losers would thus suffer not only from the effects of the mining boom but also from the political success of their industry colleagues in extracting protectionist measures from the government," he says.

It's been suggested that the miners should be required to source various supplies domestically rather than import them. A similar requirement could be imposed on government spending and on private suppliers to the government.

Such requirements would also lead to greater exchange-rate appreciation than otherwise. They would thus benefit some industries and workers but, through their aggravation of the Dutch disease effect, would damage other industries and workers.

The third option the government could choose in responding to Dutch disease is "fiscal surplus combined with lower interest rate". The government cuts spending or increases taxes to achieve or increase a budget surplus.

This would have a contractionary effect on demand in the economy, but its reduction of inflation pressure would allow the Reserve Bank to ease its monetary policy and lower the official interest rate. This, in turn, would lead to some depreciation of the exchange rate because our lower interest rates relative to those in other countries would reduce the net inflow of capital to Australia.

So the Dutch disease effect would be moderated, but at the cost of politically difficult changes in taxation and spending.

The advantage of this option is that it benefits all lagging-sector industries evenly. But, Corden argues, it's just one way of providing "exchange-rate protection". So it, too, creates winners and losers.

All tradeable industries benefit from the lower exchange rate (including the miners), but the much larger, non-tradeable sector loses from it by having to pay more for imports. The lower dollar also reduces the incentive to invest in Australian development.

I conclude from Corden's analysis there's no easy, costless way to ameliorate the downside that comes with the blessing of the mining boom. There are just options that carry more disadvantages than others.

Saturday, March 24, 2012

Is Australia living beyond its means?

It has become fashionable to say the US is ''living beyond its means''. But can the same accusation be levelled at Australia? It was a claim we used to hear often when people worried about the big deficits we were running on the current account of the balance of payments.

During the 1960s, the current account deficit averaged the equivalent of 2 per cent of gross domestic product. By the '80s, however, it was averaging 4 per cent, rising to 4.25 per cent during the '90s and noughties.

But though few people have noticed, in recent years the deficit has been falling. And for 2011 it was just 2.25 per cent.

Why the decline? And what does this tell us about whether we are or aren't living beyond our means?

It gets down to what's happening to the nation's levels of saving and investment. And James Bishop and Natasha Cassidy provide a detailed account of trends in national saving and investment in the latest Reserve Bank bulletin. Most of the facts and figures I'm using are from their article.

The nation's annual investment spending occurs in three categories: households investing in the construction of new homes, companies investing in new equipment, buildings and other structures, and governments investing in infrastructure.

The money to pay for all that investment spending has to come from somewhere and, for the most part, it's provided by the nation's savers.

Households save when they spend less than all their income on the consumption of goods and services. Companies save when they retain part of their after-tax profits rather than paying them all out to shareholders in dividends. Governments save when their raise more in revenue than they need to pay for their recurrent spending.

If Australians saved more than we wanted to invest in a period, we'd lend our excess saving to foreigners. If we want to invest more than we've saved in a period, we call on the savings of foreigners to make up the difference. We either borrow their money or we sell them Australian assets.

In fact, we almost always want to invest more than we save, and the amount we need to acquire from foreigners is called the current account deficit.

The level of our national investment spending has stayed reasonably steady over the years, somewhere below the equivalent of 30 per cent of GDP. Business investment accounts for more than half of this.

You might expect business investment to be particularly high at present because of the huge spending on new mines and natural gas facilities. But while mining investment has been exceptionally strong, other business investment spending has fallen sharply in recent years. This may be due to the effect of the high dollar on the profits of trade-exposed industries.

Public investment spending - covering such things as transport, hospitals, educational facilities and state-owned utilities - declined significantly as a share of GDP during the '90s. This partly reflected efforts to balance budgets and reduce government debt but also the trend to having the private sector, rather than the public sector, provide infrastructure such as expressways.

But this decline was reversed during the noughties, public investment reaching 6 per cent of GDP in 2010. Initially this recovery was underpinned by infrastructure spending by state governments, though in later years it was driven by the federal government's stimulus spending on school buildings and public housing. The latter has fallen off very recently, of course.

Households' investment spending on new housing usually fluctuates between 4 and 6 per cent of GDP. But it was particularly strong in the noughties and has fallen back in very recent years.

Putting these disparate trends together, national investment has actually fallen as a share of GDP in the past year or two, dropping to 27 per cent in 2011.

Australia's level of investment has almost always been significantly higher than the average for the developed economies, our 27 per cent at present comparing with their 19 per cent.

On the face of it, our desire to invest heavily in the further development of our economy hardly qualifies as a case of living beyond our means.

As the authors remind us, investment is a key driver of the productivity of labour. And when we spend on expanding the nation's capacity to produce goods and services, we're ensuring a higher material standard of living in future. The income we generate should easily cover the cost of servicing our foreign borrowings.

But it ain't quite that simple. Well-directed investment is a virtue, no doubt. But if we're having to borrow from foreigners because we're not doing enough saving of our own, that could be a problem.

Are we saving as much as we should be? Don't forget, saving equals income minus consumption. So if we're consuming too much, we won't be saving enough. But how much is enough?

As a nation we are saving - at present, a bit under 25 per cent of national income (GDP) - so we can't be accused of borrowing to finance consumption, which is surely the most obvious case of living beyond your means.

But, equally obviously, we could be saving more than we do, so are we saving enough?

Looking at the components of national saving, saving by companies has been slowly trending up over the decades and at present is at a record level of about 14 per cent of GDP.

Government saving was very weak in the '70s and '80s but, following the deep recession of the early '90s, strengthened to about 5 per cent of GDP during most of the noughties.

It's now back to zero, however, in consequence of the 2008-09 recession the pollies keep saying we didn't have.

The rate of household saving fell steadily through the '70s, '80s and '90s but began increasing sharply in the mid-noughties and is now back up to about 10 per cent of GDP, its highest since the '80s. Pulling the components together, national saving is now back up to almost 25 per cent of GDP, also its highest since the '80s. And this is about 6 percentage points higher than the average for the developed countries.

Why has our current account deficit almost halved to 2.25 per cent of GDP in the past year or two? Because national investment is down a bit on the one hand, while national saving is up a bit on the other.

The charge that we're living beyond our means has never been less applicable.

Wednesday, March 21, 2012

Endless growth and a healthy planet don't compute

Do you ever wonder how the environment - the global ecosystem - will cope with the continuing growth in the world population plus the rapid economic development of China, India and various other "emerging economies"? I do. And it's not a comforting thought.

But now that reputable and highly orthodox outfit the Organisation for Economic Co-operation and Development has attempted to think it through systematically. In its report Environmental Outlook to 2050, it projects existing socio-economic trends for 40 years, assuming no new policies to counter environmental problems.

It's not possible to know what the future holds, of course, and such modelling - economic or scientific - is a highly imperfect way of making predictions. Even so, some idea is better than no idea. It's possible the organisation's projections are unduly pessimistic, but it's just as likely they understate the problem because they don't adequately capture the way various problems could interact and compound.

Then there's the problem of "tipping points". We know natural systems have tipping points, beyond which damaging change becomes irreversible. There are likely to be tipping points in climate change, species loss, groundwater depletion and land degradation.

"However, these thresholds are in many cases not yet fully understood, nor are the environmental, social and economic consequences of crossing them," the report admits. In which case, they're not allowed for in the projections.

Over the past four decades, human endeavour has unleashed unprecedented economic growth in the pursuit of higher living standards. While the world's population has increased by more than 3 billion people since 1970, the size of the world economy has more than tripled.

Although this growth has pulled millions out of poverty, it has been unevenly distributed and has incurred significant cost to the environment. Natural assets continue to be depleted, with the services those assets deliver already compromised by environmental pollution.

The United Nations is projecting further population growth of 2 billion by 2050. Cities are likely to absorb this growth. By 2050, nearly 70 per cent of the world population is projected to be living in urban areas.

"This will magnify challenges such as air pollution, transport congestion, and the management of waste and water in slums, with serious consequences for human health," it says.

The report asks whether the planet's resource base could support ever-increasing demands for energy, food, water and other natural resources, and at the same time absorb our waste streams. Or will the growth process undermine itself?

With all the understatement of a government report we're told that providing for all these extra people and improving the living standards of all will "challenge our ability to manage and restore those natural assets on which all life depends".

"Failure to do so will have serious consequences, especially for the poor, and ultimately undermine the growth and human development of future generations." Oh. That all?

Without policy action, the world economy in 2050 is projected to be four times bigger than it is today, using about 80 per cent more energy. At the global level the energy mix would be little different from what it is today, with fossil fuels accounting for about 85 per cent, renewables 10 per cent and nuclear 5 per cent.

The emerging economies of Brazil, Russia, India, Indonesia, China and South Africa (the BRIICS) would become major users of fossil fuels. To feed a growing population with changing dietary preferences, agricultural land is projected to expand, leading to a substantial increase in competition for land.

Global emissions of greenhouse gases are projected to increase by half, with most of that coming from energy use. The atmospheric concentration of greenhouse gases could reach almost 685 parts per million, with the global average temperature increasing by 3 to 6 degrees by the end of the century.

"A temperature increase of more than 2 degrees would alter precipitation patterns, increase glacier and permafrost melt, drive sea-level rise, worsen the intensity and frequency of extreme weather events such as heat waves, floods and hurricanes, and become the greatest driver of biodiversity loss," the report says.

Loss of biodiversity would continue, especially in Asia, Europe and southern Africa. Native forests would shrink in area by 13 per cent. Commercial forestry would reduce diversity, as would the growing of crops for fuel.

More than 40 per cent of the world's population would be living in water-stressed areas. Environmental flows would be contested, putting ecosystems at risk, and groundwater depletion may become the greatest threat to agriculture and urban water supplies. About 1.4 billion people are projected to still be without basic sanitation.

Urban air pollution would become the top environmental cause of premature death. With growing transport and industrial air emissions, the number of premature deaths linked to airborne particulate matter would more than double to 3.6 million a year, mainly in China and India.

With no policy change, continued degradation and erosion of natural environmental capital could be expected, "with the risk of irreversible changes that could endanger two centuries of rising living standards". For openers, the cost of inaction on climate change could lead to a permanent loss of more than 14 per cent in average world consumption per person.

The purpose of reports like this is to motivate rather than depress, of course. The report's implicit assumption is there are policies we could pursue that made population growth and rising material living standards compatible with environmental sustainability.

I hae me doots about that. We're not yet at the point where the sources of official orthodoxy are ready to concede there are limits to economic growth. But this report comes mighty close.

Monday, March 19, 2012

How both sides stuffed the federal tax base

Two weeks ago the secretary to the Treasury, Dr Martin Parkinson, dropped a fiscal bombshell that's drawn remarkably little comment, even though - or perhaps because - it blows the budgetary calculations of both sides of politics out of the water.

Parkinson said that since the global financial crisis, federal tax revenue had fallen by the equivalent of 4 percentage points of gross domestic product [about $60 billion a year] and was ''not expected to recover to its pre-crisis level for many years to come''.

This had made the task of maintaining medium-term budgetary sustainability harder for both the Commonwealth and the states. ''For both levels of government, surpluses are likely to remain razor-thin without deliberate efforts to significantly increase revenue or reduce expenditure,'' he warned.

The most obvious (and least consequential) implication of this news is its threat to Julia Gillard's resolve to return the budget to surplus next financial year without fail.

But Gillard's problems pale in comparison to Tony Abbott's, with his oddly ideological and populist commitment to rescind both Labor's carbon tax and its mining tax without rescinding all the tax cuts and spending increases the taxes will pay for.

There seems little doubt Abbott's term in office would either be marked by an orgy of broken promises or be consumed by agonising over what spending to cut, with eternal lobbying both before and after the fact. Probably a fair bit of both.

Parkinson is telling us there's now a disconnect in the established relationship between the rate of growth in the economy and the rate of growth in tax collections. The economy can be growing at a reasonable rate without that meaning tax collections are growing strongly.

It will be a lot harder in future for politicians of either side to keep the budget in surplus. What was a doddle in the noughties will now require unremitting discipline and political courage.

And this says all the demonising of budget deficits and government debt we've heard unceasingly from the Liberals for the past three years - all of it seconded by weak-kneed Labor - will prove extraordinarily hard to live up to over the rest of this decade.

Keeping the budget in ''razor-thin surplus'' will be hard enough; eliminating net debt will be very much harder - especially since the potential-privatisations cupboard is now almost bare.

It would be the easiest thing in the world for our pollies on both sides to catch a dose of the North Atlantic disease and let deficits and debts roll on.

Should this happen, it will be because they possess neither the bloody-mindedness to live up to their professed smaller government ideal nor the courage to make and defend explicit tax increases. As in the North Atlantic economies, it will be the path of least resistance.

The fascinating question is why this economy/tax revenue disconnect has occurred. Parko says it ''reflects a combination of cyclical and structural factors''. Just so.

One part of the explanation is that the 2008-09 recession - which it suits both sides to claim we didn't have - knocked an enormous hole in tax collections.

The cumulative write-down in revenue against the forward estimates between 2007-08 and 2011-12 has been about $130 billion.

The global financial crisis put an end to asset price booms in the housing and sharemarkets - with implications for tax collections from capital gains - and in the post-crisis world it's hard to see when those markets will boom again.

The problem for state budgets is structural. Their chief revenue source is the goods and services tax. During the many decades in which households were reducing their rate of saving, their consumption spending (and hence, GST collections) grew faster than their incomes.

Now their rate of saving has stabilised, consumption and GST revenue will grow no faster than household income.

And household income will be constrained by the stable-to-declining terms of trade and weak productivity improvement.

The first phase of the resources boom was more lucrative for the taxman because the main thing that happened was hugely higher coal and iron ore prices going straight to the mining companies' (taxable) bottom line. In the second phase, the now stable-to-falling prices are accompanied by much higher accelerated depreciation deductions arising from the construction of new mines and gas facilities.

But all these things are just elements of a more fundamental explanation for the budget's new growth/tax disconnect: the Howard government's decision to cut the rates of income tax for eight years in a row.

This has robbed the income-tax scale of its propensity to bracket creep. It also represented a significant shift in the federal tax mix, greatly reducing reliance on personal income tax and greatly increasing reliance on capital gains tax and, particularly, company tax.

Get the point? This switch was made at a time when, for all the reasons we've discussed, the level of non-income tax revenue was artificially high. Now those temporary factors have evaporated, leaving us with a badly wounded tax base.

Of course, Peter Costello shouldn't get all the blame for this monumental act of fiscal vandalism. When he sprang the last three of those eight annual tax cuts on Labor in the 2007 election campaign, it unhesitatingly matched him. And it insisted on delivering them, even after their structural folly must have become apparent.

This means neither side of politics wants to acknowledge the huge hole they've driven into the budget. When the pollies won't admit it, the econocrats can't either. And all the rest of us sheep take our lead from whatever nonsense the pollies do want to talk about.

Saturday, March 17, 2012

Why the economy isn't splitting in two

The news from last week's national accounts seemed very clear and very worrying: the economy was splitting in two, with the mining-boom states of Queensland and Western Australia roaring off into the future, leaving the rest of Australia going nowhere fast.

Over the year to December, state final demand grew by more than 11 per cent in WA and by 10 per cent in Queensland, but by about 1.5 per cent in the rest of Australia.

Fortunately, the true position isn't nearly as bad as that, as Kathryn Davis, Kevin Lane and David Orsmond explain in an article in the March quarter Reserve Bank Bulletin, issued this week.

The trick was that label "state final demand". When we talk about "growth" in the context of the national accounts we're talking about growth in (real) gross domestic product - the value of all the goods and services produced by the market during a period.

We focus on production because it's production that creates jobs and generates income. The equivalent of GDP at state level is gross state product.

So if you want to compare how the states are travelling you compare the growth in their GSP.

Trouble is, the Bureau of Statistics doesn't publish GSP quarterly, only annually. What it does publish quarterly is state final demand, the national equivalent of which is "domestic final demand".

Because these are the only figures available, the media (and some economists who should know better) have fallen into the habit of assuming state final demand and GSP are much the same thing.

Wrong. State final demand differs from GSP in one minor respect and one major respect: it takes no account of exports and imports. And that's not just overseas exports and imports, it's also exports and imports between the states.

In other words, when you make state final demand a substitute for GSP you're implicitly assuming each state has no trade with either the rest of the world or even the other states. Or that its trade is always in balance.

Guess what? Make such unrealistic assumptions and you get misleading results.

The authors point out that growth in spending on home building and non-mining investment over the year to December didn't vary much between the states. There were two main differences. One was that whereas consumer spending grew by about 3.5 per cent in NSW, Victoria and Queensland, it grew by 6 per cent in WA.

The other difference was the huge growth in mining investment spending in WA and Queensland. This was what did most to explain why their growth in final demand was in double figures whereas NSW and Victoria's demand growth was so modest.

But here's the point: the Reserve estimates that roughly half the spending on mining investment goes on imported equipment. Take this into account and the gap between the mining and non-mining states gets a lot smaller.

Another factor narrowing the gap is that part of the miners' spending on investment (and their ordinary operations) goes on goods and services, such as accounting and consulting services, produced in other states. And some of the workers who fly-in/fly-out take their income home to other states.

To give you an idea of how the shift from state final demand to GSP narrows the gap between the states, let's look at the most recent figures, for 2010-11 as a whole. The final demand figures show spending growth ranging from 1.4 per cent in SA to 6.5 per cent in WA - a spread of 5.1 percentage points.

But the GSP figures show production growth ranging from 0.2 per cent in Queensland (get that) to 3.5 per cent in WA - a spread of 3.3 percentage points. After WA came Victoria on 2.5 per cent, SA on 2.4 per cent, NSW on 2.2 per cent and Tasmania on 0.8 per cent.

In other words, state final demand provided a quite misleading guide to the states' ranking. Queensland does so well on spending but so badly on production because, though it gains from having a fair bit of mining, it loses from being so dependent on tourism (hard-hit by the high dollar).

In the absence of more up-to-date figures for GSP, the trick is to examine independently estimated direct and indirect measures of state activity. If the mining states really were growing five or six times faster than the other states, you'd expect that to mean they had much lower rates of unemployment and much higher rates of inflation than the others.

It's true WA's trend unemployment rate was a very low 4.1 per cent in February, but the other mainland states were all tightly bunched around the national average rate of 5.2 per cent. As for inflation, over the year to December the mining states had the lowest rates rather than the highest.

If the gap between the mining states and the rest turns out to be narrower than you expected it's because you've been misled by all the talk of a two-speed economy: mining in the fast lane, manufacturing in the slow.

In truth, and as the distinguished economist Max Corden, of the University of Melbourne, reminded us this week, it's actually a three-speed economy, with mining in the fast lane and manufacturing (plus other export and import-competing industries) in the slow lane, but with almost all other industries - the non-tradable sector - in the middle lane.

This matters because the non-tradable sector benefits from the mining boom and the high dollar in two ways: from the increase in national income brought about by the high commodity prices, and from the lower prices of imports brought about by the high dollar.

Guess what? This non-tradable sector accounts for the great majority of production and employment in all states bar WA (where mining accounts for an amazing 33 per cent of GSP).

The people of Victoria see their state as weak on mining (true) and heavily dependent on manufacturing. Not true: manufacturing accounts for 8 or 9 per cent of GSP in all states bar WA (5 per cent). Where Victoria and NSW stick out is in their dependence on the business services sector (particularly financial and insurance services), which accounts for 28 per cent and 30 per cent of GSP, respectively, compared with about 17 per cent in the other states.

It's because business services are mainly in the not-hard-hit non-tradable sector that Victoria and NSW aren't travelling too badly compared with the mining states.

Wednesday, March 14, 2012

Why we should pay more tax

In the early 1980s, not long after I got into the economic commentary business, Maggie Thatcher and Ronald Reagan were riding high and the great enthusiasm of the moment was the need for Smaller Government.

Thirty years later, government is no smaller but the attraction of the idea is undiminished.

Its latest champion is Tony Abbott, who promises to eliminate government waste and cut taxes - and return the budget to surplus. Julia Gillard isn't far behind. She'd never admit to being against smaller government, and is insistent on getting the budget back to surplus next financial year and not a day later.

Smaller government is an idea that appeals at every level. It's attractive to libertarians, economists and business people, who remain suspicious of government. And it appeals to every voter who doesn't like paying more tax.

But Ian McAuley, a lecturer in public finance at the University of Canberra, questions our uncritical support for the smaller government ideal in an extended essay published today by the Australian Collaboration, The Australian Economy: Will our prosperity be short-lived?

Contrary to some perceptions, he writes, Australia already has a small public sector and a low level of public debt. "Successive governments have kept taxes and deficits down by keeping expenditures down. As a result Australia has one of the smallest public sectors of all developed countries."

Over the seven years to 2008, taxes paid in Australia to all levels of government averaged 29 per cent of gross domestic product, compared with a developed-country average of 35 per cent. Only Japan and the United States pay less than us - 27 per cent - and that's because they run perpetual budget deficits.

If you judge it by total government spending, rather than total taxation, our spending averages 34 per cent of GDP, compared with the developed-country average of 40 per cent. (In our case, the gap between taxation and spending is covered by non-tax revenue.)

Our aversion to supposed big government includes an obsession with government debt even though, with government net debt no higher than 13 per cent of GDP, Australia's public debt is "way below the level of almost every other developed country".

Economists' and business people's support for smaller government stems from their entrenched belief that big government causes economies to malfunction. One small problem: after decades of searching they can't find evidence to support such a link.

There's no correlation between size of government and rate of economic growth. Some countries with big public sectors do well; some countries with small public sectors do badly.

Many business people - who wrongly imagine countries compete the same way firms do - worry a great deal about their country's "competitiveness". So let's examine the (highly subjective and ever-changing) World Economic Forum's global competitiveness index.

Top of the ranking in 2011 is Switzerland, with the same rate of tax to GDP as us, 29 per cent. We come 20th. The United States, with a tax rate of 27 per cent, comes fifth. But it's pipped by Finland, on fourth, with a tax rate of 44 per cent and Sweden, on third, with a rate of 48 per cent.

Denmark, the country with the highest tax rate - 49 per cent - comes eighth. Germany, with a tax rate of 36 per cent, comes sixth, while the Netherlands, with a tax rate of 38 per cent, comes seventh.

As McAuley concludes, what counts rather than size of government are the uses to which public revenues are put and whether government services are provided efficiently.

Nor is there any necessary connection between the size of a country's government and its discipline in keeping the two sides of its budget within cooee of each other and thus limiting budget deficits and avoiding excessive government debt.

When we observe the bother the Americans and various European countries have got themselves into after decades of deficits, we see the upside of our debt-and-deficit phobia.

But, as McAuley reminds us, that phobia has a downside. What is important economically, he says, is not so much the level of debt as the use to which that debt is put. If governments borrow to fund present consumption, that's unsustainable over any extended period.

"There is no reason, however, to avoid using debt to finance productive infrastructure. Well-chosen infrastructure can provide good returns," he says.

You can divide public spending into spending on public goods (including physical assets such as roads, as well as services such as health care) and "transfer payments" (such as pensions, family allowances and industry subsidies).

McAuley argues we've yielded to pressure for ever-increasing spending on transfer payments, with the share of total federal spending on social security rising from 21 per cent in 1972 to 33 per cent today. This doesn't count the ever-growing amount of revenue forgone in the form of tax concessions for superannuation, private health insurance, capital gains and much else. Many of these benefits go to people who are reasonably well-off.

Combine this with our pre-occupation with limiting overall government spending and taxation and you find we've been crowding out spending on public services. We've gone for years squeezing our spending on education - particularly tertiary education - which is really an investment in the human capital of our future workforce.

We've also neglected investment in physical infrastructure and environmental protection. But these are important investments if we're to have a prosperous economy in a world where success rests on wise use of human and natural resources.

Bottom line: the only path that's both politically feasible and economically responsible - one that sustains transfer payments while spending more on needed public services - is for us to pay higher taxes.

Monday, March 12, 2012

Abbott's audit will find all the cuts he won't make

What do punters and economists have in common? Both like to delude themselves budgets can be balanced by relatively painless cuts in government "waste" and "profligacy" without resorting to unspeakable, unthinkable tax increases.

Both like to imagine wasteful and unnecessary government spending is almost infinite and easy to identify and eliminate. Both don't like to admit the obvious: that what's wasteful to my eyes is vitally necessary to the voters and businesses that benefit from it.

In the punters' case this is mere wishful thinking; in the economists' case it stems from the libertarian, anti-government ideology hidden in their neo-classical model.

If you think Julia Gillard will have trouble finding the spending cuts to produce a paper-thin budget surplus next financial year, consider the size of Tony Abbott's fiscal credibility gap.

Actually, no one knows the amount of spending cuts Abbott would have to find to cover the multi-year cost of his many election promises. Pouncing on a figure his finance spokesman, Andrew Robb, once mentioned in passing, the government keeps claiming it's $70 billion. But the opposition has repeatedly refused to confirm that figure, or nominate any other.

It has to be in that mind-boggling vicinity, however, because Abbott went to the last election claiming to have identified $50 billion in savings (even though Treasury and the Finance Department found $11 billion of it didn't stack up).

The reason the figure's so high is not so much Abbott's new spending promises, but his pledge to rescind Labor's carbon tax and its mining tax without also reversing the various tax cuts and spending increases Labor will use the two new taxes to pay for.

That Abbott wants the cheers for promising to abolish the two taxes but not the boos that would go with abolishing the goodies they pay for is the first reason to doubt his status as a macho-man spending slasher.

His reluctance even to put a figure on the size of his savings task - let alone produce a list of his intended cuts - is the second reason.

But on Friday Abbott unveiled the magic answer to his disclosure problem. He calls it a "commission of audit". A long-experienced election spin doctor from the other side calls it "the giant asterisk", which is used to prove the Libs' promises are "fully funded". Follow the * to the fine print and you read: "details to come after election".

Abbott says it's been 16 years since the Commonwealth conducted such a top-to-bottom independent review of public spending from the perspective: "If we were to start with a clean slate, what government spending and what government programs are really required?

"The last such review was the National Commission of Audit chaired by Professor Bob Officer in 1996, following the election of the Howard government," Abbott said.

And we all remember John Howard's first budget, in August 1996, included the most extensive collection of spending cuts and savings in living memory. "As the Howard government demonstrated, prudent fiscal management is in the Coalition's DNA," Abbott said.

He promised to make establishing a commission one of his first acts. What's more, he would require it to report within four months,

so "the operations of government can be improved and streamlined while a new government has maximum political capital to take hard decisions".

Convinced? I'm not. It's become established practice for incoming coalition governments - state and federal - to set up audit commissions headed by economic hard-men. But it's equally established practice for few if any of their (often worthy) recommendations to be acted on.

That was certainly the case with Officer's report to the Howard government. Next to none of its proposals were adopted. In one notable case, Officer recommended that pensions and benefits be indexed to a much less generous version of the consumer price index.

Howard's first budget did the opposite: switching from indexing to the CPI to indexing to the more generous average weekly earnings - though Peter Costello somehow forgot to mention this hugely expensive decision in the budget papers.

No coalition government has come to office with more "political capital" than Barry O'Farrell's. Yet the audit report he commissioned from a former Treasury secretary, Michael Lambert, has been largely ignored. It wasn't "released", but you can find it languishing on the NSW Treasury website.

So much for commissions of audit. All the cost-cutting in Howard's first (and only) horror budget came from a menu put up by the people whose job it always is, Treasury and Finance.

But let's not be too misty-eyed about that budget. Its huge cuts involved a monumental breaking of election promises and Howard's retrospective invention of the core and non-core promise.

Most of the measures involved cuts in areas favoured by Labor (job creation, the ABC, Aborigines and childcare) and they made room for increased spending on Liberal favourites (private health insurance rebate, bigger grants to private schools, payments to stay-at-home mothers).

Not long after the horror budget's announcement, the economy picked up and the budget's "automatic stabilisers" raised tax collections and cut spending on the dole, rapidly returning the budget to a healthy surplus.

As soon as Howard realised the budget was generating surpluses without his help he began reversing the unpopular measures in his first budget. Then, once the resources boom began filling his coffers to overflowing, he began spending heavily.

Howard's need to accommodate some expensive spending promises pales by comparison with Abbott's need to pay for the abolition of two big taxes. He'd either have to break promises wholesale or spend his first term utterly preoccupied with finding spending cuts he was game to make.

Saturday, March 10, 2012

Economy slows though consumers spend

For weeks the Reserve Bank has been telling us the economy is growing at "close to trend", but the indicators we got this week leave little doubt we're travelling at below trend.

Had the Reserve's forecast of growth in real gross domestic product of 2.75 per cent over the year to December been achieved, this would indeed have meant the economy was expanding at close to its medium-term trend rate of growth.

But this week's national accounts showed GDP growing by a weak 0.4 per cent in the December quarter and by just 2.3 per cent over the year to December.

There are always things you can quibble with in the Bureau of Statistics' initial estimate of growth for a particular quarter. It's always rough and ready, subject to revision as more reliable figures come to hand.

But it's hard to quibble this time because the story of weakness the national accounts are telling was confirmed by the independently estimated labour-force figures published the next day.

These February figures showed about 3000 jobs a month were created in the past six months, with the rate of unemployment essentially steady at 5.2 per cent, just a bit above the rate the econocrats regard as the lowest sustainable rate we can achieve.

Something else the Reserve has been saying is that the economy's being hit by two huge, but opposing, external shocks: the expansionary effect of our high export prices and all the spending being undertaken to expand our mining capacity, but also the contractionary effect of the high exchange rate, which has reduced the international price competitiveness of our export and import-competing industries.

The economy's below-trend growth suggests the contractionary force may be gaining an edge over the expansionary force. This increases the likelihood of another cut in the official interest rate before too long.

It's important to recognise, however, just why the reported weakness in the March quarter occurred. The greatest single reason was the utterly unexpected fall of 1 per cent in business investment spending. This is actually good news in the sense it's a blip that won't be repeated this quarter. We know the mining construction boom has a lot further to run.

The greatest (but longstanding) area of weakness in the economy is spending on the construction of new homes. It fell 3.8 per cent in the quarter and 1.8 per cent over the year to December. And doesn't look like recovering any time soon.

If you combine the fall in home building with the (temporary) fall in business investment you find the total fall in private sector investment spending subtracted 0.4 percentage points from the overall growth in GDP for the quarter.

If you listen to the retail industry's propaganda you could be forgiven for thinking weak consumer spending must be a big part of the story. Even the Treasurer, Wayne Swan, is still banging on about the "cautious consumer".

But though it's true the growth in consumer spending of 0.5 per cent is on the weak side, consumption nonetheless contributed 0.3 percentage points to overall growth in the December quarter.

And over the year to December consumption grew by 3.5 per cent - that's definitely "close to trend". If consumers really were being cautious we'd be seeing this in a rising rate of household saving. In truth, the rate dropped a little in the December quarter.

But when you look through the quarter-to-quarter volatility, it's clear the saving rate has essentially been steady at about 9.5 per cent of household disposable income for the past 18 months. That's not cautious, it's prudent.

To say consumers are cautious implies that when their confidence returns they'll start spending more strongly. That's a misreading of the situation. Their spending is already growing at trend. They've got their rate of saving back to a more prudent level after some decades of loading up with debt, and from now on their spending is likely to grow at the same rate as their income grows.

What's wrong with that? Nothing. If it leaves the retailers short of customers, that's their problem. Don't be conned: in a market economy, the producers are meant to serve the consumers, not vice versa. If the retailers are selling stuff people don't want to buy - or at prices people don't want to pay - the retailers have to adjust to fit.

We don't have a problem with weak consumer spending; the retailers, who account for less than a third of all consumer spending, have a problem because consumers have switched their preferences from goods to services.

To bang on about the "cautious consumer" implies the retailers' - and, more particularly, the department stores' - problem is cyclical (it will go away as soon as consumers cheer up) rather than structural (it will last until the businesses involved do something to solve it).

A build-up in business inventories contributed 0.3 percentage points to the overall growth in GDP during the quarter. This is a temporary contribution that could be reversed in the present quarter, but Dr Chris Caton, of BT Funds Management, offers the reassuring calculation that the ratio of non-farm inventory to sales was coming off a record low.

For once, the external sector - exports minus imports - made a positive contribution to overall GDP growth during the quarter, of 0.3 percentage points. That was because the volume of exports rose 2.2 per cent, whereas the volume of imports rose only 0.7 per cent.

If you look at the figures over the full year, however, you see a very different story: export volumes in this December quarter were up only 0.8 per cent on December quarter 2010, whereas import volumes were up 12.8 per cent, causing the external sector to subtract 2.6 percentage points from through-the-year growth.

Finally, a key development that's not directly reflected in the GDP figures, but will have a dampening effect on them in coming quarters: for the first time since the global financial crisis our terms of trade have deteriorated - by 4.7 per cent in the quarter - as import prices rose and, more particularly, export prices fell.

So whereas the volume of the nation's production of goods and services (real GDP) rose 0.4 per cent, our real gross domestic income fell 0.6 per cent.

It's production that generates jobs, but the nation's real income declined because the terms on which we trade with the rest of the world deteriorated.

Wednesday, March 7, 2012

Don't let on, but property crime is down

Wow. Did you see the latest figures for the falling crime rate? Pretty good, eh? What's that, you didn't see the figures? No one told you, eh.

It's true. Despite the best efforts of the federal Minister for Justice, Jason Clare, on Sunday, the Australian Institute of Criminology's latest compilation of statistics got remarkably little attention.

Why? One reason could be that it's old news. Levels of property crime have been falling for a decade. You've long known that, right? If you have, congratulations: you're much better informed than most.

A survey conducted in NSW in 2007 found that more than 80 per cent of respondents believed property crime had been increasing or had remained stable over the past five years. Only 11 per cent said it had been falling.

So why were the media so uninterested? Because they didn't think you'd be interested. They presumed you'd prefer to have your existing beliefs reinforced rather than up-ended. But I prefer to write for the minority who want to be informed rather than humoured.

The figures show falls in all the main categories of recorded property crime - burglary, motor vehicle theft and "other theft" (pickpocketing, bag snatching and shoplifting) - across Australia in 2010.

They also show falls in all the main categories of recorded violent crime - homicide, assault, sexual assault and robbery - other than kidnapping/abduction in 2010. For the latter, the number of cases rose by 39 to 603.

But levels of crime can rise or fall from one year to the next without that proving much. What really matters is whether the longer-run trend is up or down.

The clearest evidence is of a long-run decline in recorded property crime. The number of burglaries reached a national peak of almost 440,000 in 2000, and has since halved to fewer than 220,000 a year.

The number of motor vehicle thefts reached a peak of 140,000 a year in 2001, and has now fallen by 61 per cent to below 55,000 a year. Other thefts peaked at 700,000 a year in 2001, but are now down by a third to almost 460,000 a year.

If you allow for our rising population - up by a per cent or so a year - the decline in the rate of property crime is even greater.

So, as I say, it's clear property crime has been declining for a decade. For violent crime the trend isn't as clear - except for robbery, the property crime with violence. Robberies reached a peak of almost 27,000 in 2001, but have since fallen by 44 per cent to below 15,000 a year.

It's hard to detect any trend in the level of kidnapping and abduction, though the rate is very low: 2.7 incidents per 100,000 population. You wouldn't expect to see a trend in homicide, the rate of which is also very low: 1.2 incidents per 100,000 population. But after being well above 300 a year until 2006, it's been below 300 a year since then.

No trend in the number of assaults is visible to the naked eye, but the rate of assault seemed to peak in 2007 at 840 victims per 100,000, and is now down to 770 per 100,000. If this trend is confirmed, it will be because police have begun targeting the worst-offending licensed premises.

It's estimated only about half of all sexual assaults are reported to police. The number of recorded sexual assaults rose markedly between 1996 and 2008 to 20,000 victims a year - perhaps because of growing willingness to report offences - but though the arithmetic says the rate of sexual assault has been falling modestly since 2006, I'm not sure I believe it.

So why has property crime been falling? When the decline was first observed in the early noughties, much of it was attributed to a shortage of heroin, which led to a decline in its use and, hence, a fall in thefts by heroin addicts.

That seems true enough, but though heroin prices and purity stabilised in about 2004, the fall in property crime continued. Obviously, there must be more to it.

Most criminologists believe the amount of property crime is linked to the state of the economy. Unemployment has fallen and average weekly earnings have risen in real terms since the start of the noughties, so this may well help explain why people have been less inclined to take stuff that doesn't belong to them.

Another part of the explanation for which there's solid evidence is an increase in the proportion of property offenders who are imprisoned. The story here is not so much that tougher sentences are a greater deterrent, but that the more time you spend behind bars, the less time you're able to practise your nefarious profession.

And there are other possible explanations which, though untested by researchers, seem plausible. One is increased police effectiveness. They've been pushing hard on repeat offenders and also shifting their resources to crime hot spots at "hot" times of the day or night. Their crackdown on pubs and clubs with the worst records of assaults is a case in point.

A further possibility is that success breeds success. The more the incidence of crime falls while the number of coppers remains stable or rises, the easier it ought to be to catch offenders. As for motor vehicle theft, it's likely improvements have made cars harder to pinch than they used to be.

I finish with an appeal: you may prefer to know the truth, but keep it to yourself. Please don't spoil the fun of those who like to imagine they could be swept away at any moment by the rising tide of crime.

Monday, March 5, 2012

Want better productivity? Try better education

The American con man Bernie Cornfeld's sales pitch was, "Do you sincerely want to be rich?" That is, are you prepared to pay a price to be rich? The question for Australia's business people is, do you sincerely want to raise our productivity?

It seems just about all our senior business people have taken to preaching sermons about the need to improve our flagging rate of productivity improvement, but I'm not sure how sincere they are.

Why not? Because the specific changes they say they want sound like a child's wishlist for Santa: industrial relations "reform" to reduce their workers' bargaining power, and tax "reform" to reduce the amount of tax they pay.

If chief executives were more sincere in their thirst for higher productivity - as opposed to things the government could do to make their jobs easier - they might have asked what the empirical research tells us about which changes would do most to enhance our productivity.

Had they done that, they would have found the biggest gains come from adding to human capital - that is, to the education and training of the workforce.

The productivity debate has been so superficial and self-serving you could be forgiven for not knowing that. Among all the research, consider the findings of Professor Eric Hanushek, of the Hoover institution at Stanford University, and Professor Ludger Woessmann, of the University of Munich. Because human capital is hard to measure, economists commonly fall back on the "proxy" (stand-in) of the workforce's average number of years of schooling or higher education.

The researchers collected data for 50 countries over the 40 years to 2000. They found that each additional year of schooling raised a country's average annual rate of growth in gross domestic product per person by 0.37 percentage points.

That's a significant increase. And it's consistent with the findings of many other researchers.

But Hanushek and Woessmann wanted to find a more accurate measure of human capital than just level of educational attainment.

So they constructed for each country an index of their students' performance in maths and science tests, such as those conducted by the Organisation for Economic Co-operation and Development in its program for international student assessment (PISA). Using this measure not of years of schooling but of cognitive skills, they found countries with higher test scores experienced far higher rates of growth in income per person (the very thing productivity improvement increases).

They found that if one country's test-score performance was 0.5 standard deviations (don't ask) higher than another country's in the 1960s, the first country's annual rate of economic growth per person was, on average, a full percentage point higher than the second country's over the following 40 years.

They also found, once the effect of higher levels of cognitive skills was taken into account, the significance of levels of school attainment dwindled to nothing.

So, the authors deduce, a country benefits from asking its students to remain at school for longer only if the students are learning something as a consequence.

"Higher levels of cognitive skill appear to play a major role in explaining international differences in economic growth," they say.

But could there be other factors helping to explain a country's higher rate of growth? Different researchers have identified two other important factors: the security of the country's property rights and its openness to international trade.

When Hanushek and Woessmann took those two factors into account, the positive effect of cognitive skills on average annual economic growth was reduced to 0.63 percentage points per half a standard deviation of test scores.

"This is the best available estimate of the size of the impact of cognitive skills on economic growth," they say. "Our commonsense understanding of the importance of good schools can thus be documented quite precisely.

"A highly skilled workforce can raise economic growth by about two-thirds of a percentage point every year."

Clearly, the professed searchers after higher productivity ought to be taking a lot more interest in what's happening in our schools than they are. One question they could be asking is whether it's having a few "rocket scientists" at the very top of the skills distribution that spur economic growth or if it's "education for all" that's needed.

When the researchers estimated the importance, they found each to be separately important to economic growth.

"That is, both the performance of countries in ensuring that almost all students achieve at basic levels and their performance in producing high-achieving students seem to matter," they say.

Just why this should be so isn't hard to imagine. Even if a country is simply making use of new technologies developed elsewhere - as we do - the more workers who have at least basic skills, the easier it will be for them to make use of those new technologies.

On the other hand, some workers need a high level of skills so they can help adapt the new technologies to their countries' particular situation.

Of course, it's not just the broad community that benefits from the accretion of human capital. As Dr Ben Jensen, of the Grattan Institute, has pointed out, improving the effectiveness of teaching - which is what increases students' cognitive skills - has substantial benefits for the students themselves.

"Young people who stay in school and invest in further education can expect to earn an additional 8 to 10 per cent per year for each additional year of education they undertake," he says.

But while we're focusing on the acquisition of education as a means to raise our material standard of living, let's not forget that education is also an end in itself. It allows us to lead broader, more inquiring, more comprehending lives.

Saturday, March 3, 2012

All work creates wealth

You'll find this hard to believe but not every reader of my columns agrees with everything I write. And when I wrote recently that jobs lost in manufacturing would be offset by jobs gained in other parts of the economy, one reader emailed to say he could see a gaping hole in my argument.

My point was that the high dollar wouldn't destroy jobs so much as "displace" them: shift them from contracting industries to expanding industries.

This would happen because the high dollar was the market economy's way of helping us restructure our economy to take full advantage of the marked and long-lasting change in what the rest of the world wants to buy from us at higher prices (primary commodities) and sell to us at lower prices (manufactures and tradeable services such as tourism).

So employment would fall in manufacturing and tourism but would increase in mining and construction, as well as in the services sector.

(This is not to imply that all the workers losing their jobs in manufacturing would move simply and easily to jobs in the expanding industries. Some may encounter difficulty making the switch, which is why governments should help them retrain and relocate. Some older workers will never make the transition. And some of the new jobs will go to people from outside manufacturing.)

People are often vague about which industries are included in the services sector, so I offered some examples of those likely to expand: "health, education and training, public administration, the science professions and arts and recreation".

Ah, said my reader, gotcha. "Surely the funding for many of the job types identified comes from the public purse, that money being generated by taxes on employees, companies, profits from investment in local manufacturing and [from] the businesses, secondary and tertiary, generated from manufacturing," he wrote.

"Where is your viable break-even point here between job creation and taxes/wealth creation sufficient to create those [public sector] jobs?"

See his argument? You have manufacturing and the rest of the private sector it supports, which creates the wealth and the jobs and pays the taxes governments use to finance all their activities, creating public sector jobs in the process.

If you allow the manufacturing sector to contract, you erode the economy's wealth- and job-creating capacity, thus reducing the tax governments are able to collect and use to create jobs in the public sector.

So there must be some point below which you can't allow the private sector to fall, otherwise you also destroy jobs in the public sector.

Convinced? I'm not. The reader's riposte is built on two related misconceptions.

One is that the private sector is productive - it generates the wealth and creates the jobs - whereas the public sector is essentially parasitic: it appropriates some of the private sector-created wealth via taxation and redistributes it to presumably worthy causes, employing public servants in the process.

Sorry, not true. What is this "wealth" that's being created? It's more accurately described as income: the income that's generated when employers and employees produce all the goods and services that make up the nation's gross domestic product.

So "wealth" is generated when people go to work and their employer provides them with the equipment and direction to do what they do. The workers receive income in return for their work. They pay some of that income in direct and indirect taxes but most of the rest they spend on the goods and services they need, which generates continuing demand for all the stuff that they and other workers have produced.

If you think this description of the economy is circular, you're right: supply (production) creates demand (spending) and demand leads to supply. Point is, there's no important distinction between goods and services produced in the private sector and those produced in the public sector. Nor between goods and services paid for in the marketplace and those paid for via taxation.

To imagine otherwise is to imply that someone working on a production line producing cans of beans is productive (generating "wealth") but doctors and nurses who fix broken legs and save lives, or people who teach our children to read and write, are unproductive (generating no wealth).

Many doctors are self-employed and there are plenty of private hospitals; many teachers work for non-government schools. We're being asked to believe that those in the private sector are productive wealth-generators but those in the public sector are unproductive wealth-appropriators.

We could, if we wished, leave the whole of healthcare and education to the private sector. Would that make the economy vastly more productive? Hardly. (What it would mean is a lot of people being unable to afford education or healthcare.)

The reader's argument also implies that only people working in the private sector pay tax and contribute to the cost of publicly-provided goods and services. Rubbish. Everyone who works is productive and everyone who earns and spends income pays taxes, regardless of their sector.

The second misconception is that economies are built like the pharaohs built the pyramids: one level on top of another. You start with a base of primary industry (farming and mining), then put secondary industry (manufacturing) on top of that and tertiary industry (services) on top of that.

Take away one of the lower building blocks and you lose the basis on which to build the levels above it. If you had no manufacturing sector, for instance, how could you have a services sector?

If you were building a closed economy - one that didn't trade with other economies - that's the way you'd do it. But, like all economies, we have considerable trade with other countries. Why? Because it makes us wealthier.

We specialise in producing things we're relatively good at, they specialise in producing what they're relatively good at, and we trade. That leaves both sides better off and means you don't have to do everything to have a viable economy. Indeed, the more you insist on doing things you're not good at, the more you forgo wealth.

These days, the rich countries of Europe have little mining and waste taxes propping up their inefficient farmers when they could buy from us more cheaply. Our natural endowment (plus 200 years of experience) makes us highly-efficient producers of rural and mineral commodities, which are now in great demand as poor countries develop. The workforces in the rich countries are too highly skilled and expensive for them to be used to make things in factories, so manufacturing in these countries is shifting to Asia.

So where are the jobs being created in the rich economies? In the services sector. The range of simple to sophisticated services we can perform for other people in our country - or for foreigners - is infinite.

And everyone with a job that involves "doing things" is generating wealth.