AI will make or break us - probably a bit of both

Depending on who you talk to, AI – artificial intelligence – is the answer to the rich world’s productivity slowdown and will make us all much more prosperous. Or it will lead to a few foreign mega tech companies controlling far more of our lives than they already do.

So, which is it to be? Well, one thing we can say with confidence is that, like all technological advances, it can be used for good or ill. It’s up to us and our governments to do what’s needed to ensure we get a lot more of the former than the latter.

If all the talk of AI makes your eyes glaze (or you’re so old you think AI stands for artificial insemination), let’s just say that AI is about making it possible for computers to learn from experience, adjust to new information and perform human-like tasks, such as recognising patterns, and making forecasts and decisions.

Scientists have been talking about AI since the 1950s, but in recent years they’ve really started getting somewhere. It took the telephone 75 years to reach 100 million users, whereas the mobile phone took 16 years and the web took seven.

You’ve no doubt seen the fuss about an AI language “bot”, ChatGPT, which can understand questions and generate answers. It was released last year and took just two months to reach 100 million users.

This week the competition minister, Dr Andrew Leigh, gave a speech about AI’s rapidly growing role in the economy. What that’s got to do with competition we’ll soon see.

He says the rise of AI engines has been remarkable and offers the potential for “immense economic and social benefits”.

It “has the potential to turbocharge productivity”. Most Australians work in the services sector, where tasks requiring the processing and evaluation of information and the preparation of written reports are ubiquitous.

“From customer support to computer programming, education to law, there is massive potential for AI to make people more effective at their jobs,” Leigh says.

“And the benefits go beyond what shows up in gross domestic product. AI can make the ideal Spotify playlist for your birthday, detect cancer earlier, devise a training program for your new sport, or play devil’s advocate when you’re developing an argument.”

That’s the optimists’ case. And there’s no doubt a lot of truth to it. But, Leigh warns, “it’s not all upside”.

“Many digital markets have started as fiercely competitive ecosystems, only to consolidate [become dominated by a few big companies] over time.”

We should beware of established businesses asserting their right to train AI models on their own data (which is how the models learn), while denying access to that data to competitors or new businesses seeking to enter the industry.

Leigh says there are five challenges likely to limit the scope for vigorous competition in the development of AI systems.

First, costly chips. A present, only a handful of companies has the cloud and computing resources needed to build and train AI systems. So, any rival start-ups must pay to get access to these resources.

As well, the chipmaker Nvidia has about 70 per cent of the world AI chips market, and has relationships with the big chip users, to the advantage of incumbents.

Second, private data. The best AI models are those trained on the highest quality and greatest volume of data. The latest AI models from Google and Meta (Facebook) are trained on about one trillion words.

And these “generative” AI systems need to be right up-to-date. But the latest ChatGPT version uses data up to only 2021, so thinks Boris Johnson and Scott Morrison are still in power, and doesn’t know the lockdowns are over.

Which brings us, third, to “network effects”. If the top ride-hailing service has twice as many cars as its rival, more users will choose to use it, to reduce their waiting times. So, those platforms coming first tend to get bigger at the expense of their rivals.

What’s more, the more customers the winners attract, the more data they can mine to find out what customers want and don’t want, giving them a further advantage.

This means network effects may fuel pricing power, entrenching the strongest platforms. If AI engines turn out to be “natural monopolies”, regulators will have a lot to worry about.

Fourth, immobile talent. Not many people have the skills to design and further develop AI engines, and training people to do these jobs takes time.

It’s likely that many of these workers are bound by “non-compete” clauses in their job contracts. If so, that can be another factor allowing the dominant platforms to charge their customers higher prices (and pay their workers less than they should).

Finally, AI systems can be set up on an “open first, closed later” business plan. I call it the drug-pusher model: you give it away free until you get enough people hooked, then you start charging.

Clearly, the spread of AI may well come with weak competitive pressure to ensure customers get a good deal and rates of profit aren’t excessive.

Just as competition laws needed to be updated to deal with the misbehaviour of the oil titans and rail barons of 19th century America, so too we may need to make changes to Australian laws to address the challenges that AI poses, Leigh says.

The big question is how amenable to competition the development of AI is. In other, earlier new industries, competition arose because key staff left to start a competing company, or because it made sense for another firm to operate in a different geographic area, or because customers desired a variant on the initial product.

“But if AI is learning from itself, if it is global, and if it is general, then these features may not arise.” If so, concentration maybe more likely than competition.

Get it? If we’re not careful, a few foreign mega tech companies may do better out of AI than we do.

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Albanese's big chance to improve inflation, productivity and wages

Are Anthony Albanese and his ministers a bunch of nice guys lacking the grit to do much about their good intentions? Maybe. But this week’s announcement of a review of competition policy raises hope that the nice guys intend to make real improvements.

The review, which will provide continuous advice to the government over the next two years, has been set up because “greater competition [between Australia’s businesses] is critical for lifting dynamism, productivity and wages growth [and] putting downward pressure on prices”, Treasurer Jim Chalmers says.

As I wrote on Monday, the great weakness in our efforts to reduce high inflation has been our assumption that its causes are purely macroeconomic – aggregate demand versus aggregate supply – with no role for microeconomics: whether businesses in particular industries have gained the power to push their prices higher than needed to cover their increased costs.

But it seems Chalmers understands that. “Australia’s productivity growth has slowed over the past decade, and reduced competition has contributed to this – with evidence of increased market concentration [fewer businesses coming to dominate an industry], a rise in markups [profit margins] and a reduction in dynamism [ability to change and improve] across many parts of the economy,” he says.

The former boss of the Australian Competition and Consumer Commission, Rod Sims, had some pertinent comments to make about all this at a private business function last week.

He observes that “companies worked out long ago that the essence of corporate strategy is to gain market power and erect entry barriers. Profits from ‘outrunning’ many competitors from a common starting point are generally small; profits from gaining market power are usually large.

“Businesspeople know that when the number of competitors gets too large, price competition is often the result, and that this ‘destroys shareholder value’ or, alternatively put, helps consumers.”

Sims says the goals of growing and sharing the economic pie are being damaged in Western economies, and in Australia, by inadequate competition leading to market power. But, aside from the specialists, the economics profession more broadly has been slow to realise this and factor it into policy responses.

Australia has an extremely concentrated economy, Sims says. We have one dominant rail freight company operating on the east coast, one dominant airline with two-thirds of the market, two beer companies, two ice-cream sellers and two ticketing companies, all with a 90 per cent share of their markets.

We have two supermarkets with a combined market share of about 70 per cent. We have three dominant energy retailers and three dominant telecommunications companies. We have four major banks, with a 75 per cent share of the home mortgage market.

This is much greater concentration than in other developed countries. And, as you’d expect, the profit margins of these companies generally exceed those of comparable companies overseas.

The centuries that businesses have spent pursuing economies of scale explain why we don’t have – and shouldn’t want - the huge number of small firms assumed by the economic theory burnt on the brains of most economists.

But, Sims argues, our relatively small population doesn’t justify the much greater concentration of our industries. For one thing, studies of Australian industry sectors show that the returns to scale stop increasing well before market shares are anything like as high as they are in Australia.

For another, Australia’s modest size doesn’t explain why our industries are getting ever more concentrated, so that our key players are less likely to be challenged by competitors.

And it’s not just our high concentration, it’s also that we see large asset-managing institutions with big shareholdings in most of the firms dominating an industry. Thus, asset managers have an interest in keeping the whole industry’s profits high by limiting price competition between the companies.

One study, of 70,000 firms in 134 countries, found that the average prices charged by our listed companies were 40 per cent above the companies’ marginal cost of production in 1980, and about the same in the late 1990s. But by the early 2000s, average prices were 40 per cent above marginal cost. By 2010, they’d risen to 50 per cent above, and by 2016 it was nearly 60 per cent.

Analysis by federal Treasury has found that our companies’ markups increased over the 13 years to 2017.

The evidence in Australia and overseas is that in concentrated industries we see less dynamism, lower investment and lower productivity, Sims says. Our productivity performance has been very poor at a time when our focus on pro-competition public policy appears to have been lost.

It’s not hard to believe that the latter explains the former. “We run harder when competing versus when we run alone,” Sims says.

Our Treasury’s research also shows that firms in concentrated markets are further from the productivity frontier as there’s less incentive to keep up.

And market concentration also has implications for wage levels. Where labour mobility – the ease with which people move between employers – is reduced, wage levels are lower.

But high industry concentration means fewer firms that workers can move to, bringing relevant skills, and fewer new firms entering the industry. Less competition for workers means lower wages.

“Non-compete clauses” make the problem worse. Recent Australian studies have shown that more than one in five employees are prevented from working for competitors under such contract terms, often even in fairly low-skilled jobs.

Another finding is that the benefits of improved productivity are less shared with workers in concentrated industries. The share of productivity gains going to workers has declined by 25 per cent in the last 15 years, Sims says.

So next time some business person, politician, Reserve Bank governor or other economists tells you higher productivity automatically increases everyone’s wage, don’t fall for it. Used to be true; isn’t any more.

All this says that if the Albanese government is fair dinkum about getting inflation down and productivity and wages up, it will at least ban non-compete clauses and tighten up our merger laws.

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We won't fix inflation while economists stay in denial about causes

Led on by crusading Reserve Bank governors, the nation’s economists are determined to protect us from the scourge of inflation, no matter the cost in jobs lost.

But there’s a black hole in their thinking about the causes of inflation, only some of which must be stamped on. Others can be ignored. Meanwhile, here’s another sermon demanding the government act to raise productivity.

In your naivety, you may think that inflation is caused by businesses putting up their prices. But economists know that’s not the problem. Businesses raise their prices only in response to “market forces”. When demand for their products exceeds the supply, businesses seize the chance to raise their prices.

In your ignorance, you may think they do this out of greed, a desire to increase “shareholder value” at the expense of their customers. But that’s the wrong way to look at it.

In raising their prices, businesses aren’t being opportunistic, they’re only doing what comes naturally, playing their allotted role in allowing the “price mechanism” to bring demand and supply back into balance.

As balance is restored, the price will fall back, pretty much to where it was before. What? You hadn’t noticed? Funny that, neither had I.

No, what causes prices to keep rising at a rapid rate is when the greedy workers and their unions force businesses to increase their wages in line with the rise in the cost of living. Can’t the fools see that this merely perpetuates the rapid rise in prices?

So, what we need to get inflation down quickly is for workers to take it on the chin. They can have a bit of a pay rise – say, 2.5 per cent – but nothing more, especially when there’s been no increase in the productivity of their labour.

This will cut the workers’ real incomes and lower their standard of living, of course, but that can’t be helped. It’s the only way we can make them stop spending as much, so businesses won’t be able to get away with continuing to raise their prices by more than 2.5 per cent.

But cutting real wages probably won’t be enough to stop businesses raising their prices so high, so we’ll need to raise interest rates and really put the squeeze on workers with big mortgages. Sorry, nothing else we could do.

Yet another worry is our return to full employment. If the demand for labour exceeds its supply, that would allow the suppliers of labour – aka workers – to raise their prices – aka wages – and that would never do.

Indeed, our history-based calculations say the unemployment rate has already fallen below the level that causes wage and price inflation to take off. It hasn’t yet, but it will.

But not to worry. As incoming Reserve Bank governor Michele Bullock explained in a speech extolling full employment, the Reserve estimates it should only be necessary to raise the rate of unemployment by 1 percentage point to 4.5 per cent to get inflation back down to where we want it.

What! Cried the punters in stunned amazement. To get inflation down you will knowingly put about 140,000 workers out of work? How could you be so utterly inhuman?

What stunned and amazed the nation’s economists is that anyone should be surprised or offended by this. Don’t they know that’s the way we always do it? And 140,000 job losses would be getting off lightly.

Just so. When, as now, the Reserve Bank and the government accidentally overstimulate the economy, allowing businesses to increase their prices by more than they need to, what we always do to stop businesses raising their prices is bash up their customers until the fall-off in households’ spending – caused partly by people losing their jobs – makes it impossible for businesses to keep increasing their prices.

Problem solved. Standard practice is to put a stop to businesses’ opportunism – their “rent-seeking” as economists say – by bashing up their workers and customers until the businesses desist.

But what never happens is that the level of prices falls back to about where it was before the econocrats stuffed up – as the economists’ price-mechanism theory promises it will.

Why doesn’t the theory work? Because what’s required to make it work is intense competition between many small firms. When one firm decides to raise its prices and fatten its profit margin, the others undercut it and it either pulls its head in or goes out backwards.

In the real world, industries are increasingly dominated by just a few huge firms – firms that have become so mainly by taking over their smaller competitors. This is true in all the rich economies, but none more so than ours.

Economists know that “oligopolies” form because it’s easier for a few big firms to gain a degree of control over the prices they charge (whereas the price-mechanism theory assumes they’re too small to have any control).

The few big players compete on marketing and advertising, and using minor product differentiation, but never on price. When prices rise, they rise together – and rarely come back down.

Economists know all this – it’s knowledge gained and taught by economists – but it’s classed as “microeconomics”, whereas the econocrats seeking to manage the economy and keep inflation low specialise in “macroeconomics”. And they never join the dots – though that’s changing in other countries.

This year the European Central Bank, the International Monetary Fund and the Organisation for Economic Co-operation and Development have delved into the national accounts and determined that rising profit margins explain a high proportion of the recent inflation surge.

But when the Australia Institute replicated this analysis for Australia, both Treasury and the Reserve Bank used dodgy graphs and dubious arguments to dismiss its work as “flawed”.

Entrenched inflation only emerged as a problem in the 1970s. After much debate, the world’s economists decided the problem was caused by powerful unions, whose expectations of continuing high inflation caused a “wage-price spiral”, which could only be broken by using high interest rates to put the economy into recession.

This is the thinking we’ve had full strength from the Reserve for the past year or more. Since the 1970s, however, multiple developments have weakened the unions’ bargaining power, while decades of takeovers have increased our big businesses’ pricing power – without the econocrats noticing.

And despite their unceasing sermons about the need for governments to increase national productivity, it’s never occurred to them that the primary driver of productivity improvement is intense competition between businesses.

The calls by successive heads of the Australian Competition and Consumer Commission for stronger powers to block mergers that would “substantially lessen competition” have gained no support from the Reserve, Treasury or economists generally.

But we won’t fix inflation until we have stronger laws defending competition.

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Less competition reduces the power of interest rates to cut inflation

The ground has been shifting under the feet of the world’s central bankers, including our own Dr Philip Lowe, the outgoing chief of the RBA. This has weakened the power of higher interest rates to get inflation down.

Like all economists, central bankers believe their theory – their “model” – gives them great understanding of how the economy works and what they have to do to keep inflation low and employment high.

They know, for instance, that inflation – rising prices – occurs when the demand for goods and services exceeds the economy’s ability to supply those goods and services. So they can use an increase in interest rates to discourage businesses and households from spending so much.

This will reduce the demand for goods and services, bringing it into alignment with supply and so stop it causing prices to rise so quickly. It will also slow the rate at which the economy’s growing, of course.

But, with a bit of care, they won’t need to push interest rates so high the economy goes into “recession”, when demand (spending) becomes so weak that the economy gets smaller, causing some businesses to go bust and many workers to lose their jobs.

This theorising has worked reasonably well for many years, leading central bankers to be confident they know how to fix the present surge in inflation.

But the economy keeps changing, particularly as we keep using advances in technology to improve the range of goods and services we produce, and the way we produce them.

One consequence of our businesses’ unending pursuit of labour-saving technology – more of the work being done by machines and less by humans – has not been fewer jobs, but bigger factories and businesses.

As in all the rich economies, many industries are now dominated by just a few huge companies. In our case, we’re down to just four big banks, three big power companies, three big phone companies, two airlines and two supermarket chains. And that’s before you get the handful of giants dominating the rich world’s internet hardware, software and platforms.

Trouble is, when just a few firms dominate an industry, they gain “market power” – the power to hold their prices well above their costs; to increase their “markup”, as economists say.

The size of markups is a measure of the degree of competition in an industry. When competition between firms is strong, markups are low. When competition is weak, markups are high.

There is much empirical evidence that industries in the rich countries have become more concentrated over time, and markups have risen. And, as I’ve written before, Australia’s no exception to this trend.

In economics, “monopoly” means just one seller. “Monopsony” means just one buyer. So, when a firm has a degree of monopoly power, it can overcharge its customers. When a firm has a degree of monopsony power – when workers don’t have many employers to pick from – it can underpay its workers.

Researchers have found much evidence of labour-market power. And again, I’ve written before about the evidence this, too, is happening in Australia.

But this week, at the annual Australian Conference of Economists, federal Competition Minister Andrew Leigh, himself a former economics professor, drew attention to two recent International Monetary Fund research papers suggesting that a lack of competition is reducing the effectiveness of monetary policy – the manipulation of interest rates – in influencing inflation.

The first paper, by Romain Duval and colleagues, uses American data and data from 14 advanced economies to find that, compared with low-markup firms, high-markup firms are less likely to respond to changes in interest rates. The level of their sales changes less, as do their decisions about future investment in production capacity.

So, fat markups mean companies are less likely to change their behaviour. They’re not likely to cut their investment spending, for example.

This means more of the pressure to respond to higher rates will fall on households with big mortgages, but also on firms with low markups.

The second paper, by Anastasia Burya and colleagues, uses online job ads from across the United States to find that in regions where firms have a lot of labour-market power – that is, where workers don’t have much choice of where to work – those firms can hire workers without having to offer higher wages to attract the people they need.

This is the opposite of what standard theory predicts. It’s bad news for workers, who could have expected strong demand for labour to push up wages.

But another way to look at it is that, where big firms have labour-market power, there’s little relationship between employment and the change in wages. If so, conventional calculations of the “non-accelerating-inflation rate of unemployment” – the lowest point to which unemployment can fall without causing wages to take off – will give wrong results, encouraging central banks to keep unemployment higher than it needs to be.

And at times when price inflation is too high, unemployment will have to rise by more than you’d expect to get the rate of inflation back down to where you want it. How do you bring about a bigger rise in unemployment? By increasing interest rates more than you expected you’d have to.

So, whether it’s inadequate competition in the markets for particular products, or inadequate competition in the market for workers’ labour, lack of competition makes monetary policy – moving interest rates – less effective than central bankers have assumed it to be.

The model of how markets work that central bankers (and most other economists) rely on assumes that the competition between firms – including the competition for workers – is intense.

In the real world, however, markets have increasingly become dominated by just a few huge firms, which has given them the power to keep prices higher than they should be, and wages lower than they should be.

Leigh, Minister for Competition, gets the last word: “If you care about central banks being able to do their jobs, then you should care about a competitive and dynamic economy.”

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Ever wondered why your wages aren't rising?

It’s dawning on people that when the competition between businesses isn’t strong, firms can raise their prices by more than the increase in their costs, and so fatten their profit margins. What’s yet to dawn is that weak competition also allows businesses to pay their workers less than they should.

In standard economic theory, it’s the intense competition between firms that prevents them from overcharging for their products and earning more than a “normal” profit.

Normal profit gives the owners of the firm just sufficient return on the capital they’ve invested to stop them leaving the industry and trying their luck elsewhere.

The theory assumes the industry has numerous firms, each one too small to influence the market price. In today’s world, however, many markets are dominated by just two, three or four huge firms.

These firms are big enough to influence the market price, especially when it’s so easy for them to collude tacitly with their rivals.

We see the four big banks doing this every time interest rates are raised. They have an unspoken agreement not to compete on price.

EverI say they have “pricing power”, but many economists say they have “monopoly power”. How can a handful of firms have monopoly power? Because economists don’t use that term literally. On a scale of one to 1000 firms, we’re right down the monopoly end.

Dr Andrew Leigh, the Assistant Minister for Competition, and a former economics professor, has been giving a series of speeches about recent empirical studies on how competitive our markets are.

In one, he quoted the findings of Jonathan Hambur, a researcher who pivots between Treasury and the Reserve Bank, that Australian firms’ “mark-ups” – the gap between their cost of production and their selling price – have been rising steadily.

But in a further speech this month, Leigh turned the focus from what “market concentration” (among a few massive companies) means for the industry’s customers, to what it means for its employees.

So, in econospeak, we’re moving from monopoly to “monopsony”. Huh? Taken literally, monopoly means a market in which there’s a single seller meeting the demand for the product. Monopsony means there’s a single buyer from the people supplying the inputs to production. Workers supply the firm with the labour it needs.

The term was introduced by Joan Robinson, a colleague of Keynes at Cambridge, who was among the first to question the standard theory of how markets work. She was 30 in 1933 when she published her dissenting view that truly competitive markets were rare.

She argued that monopsony was endemic in the labour market and employers were using it to keep wages low. If there are few employers competing for workers, those workers have fewer “outside options” (to move to another firm offering higher pay or better conditions).

This limits workers’ bargaining power and gives employers the power to keep wages lower.

At the time, few economists took much interest. But in recent years there’s been a growing focus on market power by academic economists.

For instance, monopsony was cited in a US Supreme Court ruling against Apple in 2019. A report by Democrats in the US House of Representatives accused Amazon of using monopsony power in its warehouses to depress wages in local markets.

Evidence from the US, Britain and Europe has demonstrated that increases in labour market concentration – fewer employers to work for – are associated with lower wages.

Leigh says economists have long known that people in cities tend to earn more than those in regional areas. His own research found that when someone moves from a rural area to a major Australian city, their annual income rises by 8 per cent.

“The economics of monopsony suggests that an important part of the urban wage premium can be explained by greater employer competition in denser labour markets,” Leigh says.

Leigh reminds us that Australia’s average full-time wage ($1808 a week last November) was only $18 a week higher than it was 10 years ago, after allowing for inflation. Many things would explain this pathetic improvement, but one factor could be employers’ monopsony.

We know that the rate at which people move between employers has fallen. But over a person’s working life, the biggest average wage gains come when people switch employers. And when some people leave, the bargaining power of those who stay is increased.

This decline in people moving could be caused by increased employer monopsony. Hambur has done a study of employment concentration between 2005 and 2016.

He found that, within industries where concentration rose, growth in real wages over the decade was significantly lower.

When a firm has a large share of the industry’s employment, the gap between the value of the work a worker does, and the wage they’re paid in return, tends to grow.

He found that employment in regions close to major cities is twice as concentrated as in the cities. In remote areas it’s three times.

Read this carefully: Hambur found that labour markets had not become more concentrated over the decade. But at every degree of concentration, its negative impact on wages had more than doubled.

So, employers’ market power could well be a factor helping to explain the virtual absence of real wage growth over a decade. Hambur finds that the greater impact of employer concentration may have caused wage growth between 2011 and 2015 to be 1 per cent lower than otherwise.

This would help explain why not all the (weak) growth in the productivity of labour during the period was passed through to real wages – as conventional economists and business people always assure us it will be. Weak competition allowed employers to keep a lot of it back for themselves.

Part of the competitive process is new firms entering the industry. New firms usually poach staff away from the existing firms. But we know the rate of new entry has declined.

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RBA inquiry should propose something much better

The inquiry into the Reserve Bank, due to report this month, will be disappointing if it does no more than suggest modest improvements in the way it does its job. The question it should answer is: should we give so much responsibility to an institution with such a limited instrument – interest rates – and with such a narrow focus?

In Reserve Bank governor Dr Philip Lowe’s lengthy appearance before the House of Representatives Economics Committee last month, he spent much of his time reminding critics that he only has one tool, so he can’t do anything to resolve the problems they were complaining about.

He’s right. But if the problems are real, and he can’t do anything about them, why should the central bank be the top dog when it comes to managing the economy, and Treasury’s job be limited to worrying about debt and deficit?

Shouldn’t the greatest responsibility go to an institution with more instruments, and ones capable of doing more tricks?

By the way, if you’re wondering why I’ve had so much to say recently about the limitations of monetary policy and the questionable convention of making it dominant in the management of the macroeconomy, it’s because it’s the obvious thing to do while we’re holding an inquiry into Reserve Bank’s performance.

Frenchman Olivier Blanchard, one of the world’s top macroeconomists, recently caused a storm when he tweeted about “a point which is often lost in discussions of inflation and central bank policy”.

“Inflation,” he wrote, “is fundamentally the outcome of the distributional conflict between firms, workers and taxpayers. It stops only when the various players are forced to accept the outcome.”

Oh, people cried, that can’t be right. Inflation is caused when the demand for goods and services exceeds the supply of them.

In truth, both propositions are correct. At the top level, inflation is simply about the imbalance between demand and supply. At a deeper level, however, “distributional conflict” between capital and labour can be the cause of that imbalance.

Businesses add to inflation when they seek to increase their profit margins. Workers and their unions add to inflation when they seek to increase their real wages by more than the productivity of labour justifies.

But this way of thinking is disconcerting to central bankers because – though there may well be a way of reducing inflation pressure by reducing the conflict between labour and capital – there’s nothing the Reserve can do about it directly.

Central banks’ interest-rate instrument can fix the problem only indirectly and brutally: by weakening demand (spending) until the warring parties are forced to suspend hostilities. So distributional conflict is the first thing monetary policy (the manipulation of interest rates) can’t really fix.

Then there’s inflation caused by other supply constraints, such as the pandemic or wars. Again, monetary policy can’t fix the constraint, just bash down demand to fit.

The next things monetary policy doesn’t do are fairness and effectiveness. When we’re trying to reduce inflation by reducing people’s ability to consume goods and services, it would be nice to do so with a tool that shared the burden widely and reasonably evenly.

A temporary increase in income tax or GST would do that, but increasing interest rates concentrates the burden on people with big mortgages. This concentration means the increase has to be that much greater to achieve the desired slowing in total consumer spending.

A further dimension of monetary policy’s unfairness is the way it mucks around with the income of savers. Their interest income suddenly dives when the Reserve decides it needs to encourage people to borrow and spend.

In theory, this is made up for when the Reserve decides to discourage people from borrowing and spending, as now. In practice, however, the banks drag their feet in passing higher interest rates on to their depositors. But it’s rare for the Reserve even to chivvy the banks for their tardiness.

Governments need to be free to encourage or discourage consumers from spending. But where’s the justification for doing this by riding on the backs of young people saving for a home and old people depending on interest income to live on?

The next thing monetary policy doesn’t do is competition. What’s supposed to keep prices no higher than they absolutely need to be is the strength of competition between businesses. You’d think this would be a matter of great interest to the Reserve, especially since there are signs that businesses increasing their “markups” are part of the present high inflation.

But only rarely does the Reserve mention the possibility, and only in passing. It gives no support to the Australian Competition and Consumer Commission’s efforts to limit big firms’ pricing power.

The final thing monetary policy doesn’t do is housing. The Reserve is right to insist that its increases in interest rates aren’t the main reason homes have become so hard to afford.

The real reason is the failure of governments to increase the supply of homes in the places people want to live – close to the centre of the city, where the jobs are – exacerbated by their failure to provide decent public transport to outer suburbs.

But the ups and downs of mortgage interest rates must surely be making affordability worse. To this, Lowe’s reply is that, sorry, he’s got a job to do and only one instrument to do it with, so he can’t be worried about the collateral damage he’s doing to would-be young home buyers.

Well, he can’t be worried, but his political masters can. And if they’re not game to fix the fundamental factors driving up house prices, they should be willing to create an instrument for the short-term management of demand that doesn’t cause as many adverse side effects as using interest rates does.

The one big thing going for monetary policy as a way of keeping the economy on track is that the Reserve’s independence of the elected government allows it to put the economy’s needs ahead of the government’s need to sync the economy with the next election.

But, as various respected economists have pointed out, there’s no reason the government can’t design a fiscal instrument, giving another body the ability to raise or lower it within a specified range, and making that body independent, too.

It’s the Reserve Bank inquiry’s job to give the government some advice on why and how it should make a change for the better.

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Central banking: don't mention business pricing power

Despite the grilling he got in two separate parliamentary hearings last week, Reserve Bank governor Dr Philip Lowe’s explanation of why he was preparing mortgage borrowers for yet further interest rate increases didn’t quite add up. There seemed to be something he wasn’t telling us – and I think I know what it was.

We know that, as well as rising mortgage payments, we have falling real wages, falling house prices and a weak world economy. So it’s not hard to believe the Reserve’s forecasts that the economy will slow sharply this year and next, unemployment will rise (it already is), and underlying inflation will be back down to the top of the 2 per cent to 3 per cent target range by the end of next year.

So, why is Lowe still so anxious? Because, he says, it’s just so important that the present high rate of inflation doesn’t become “ingrained”. “If inflation does become ingrained in people’s expectations, bringing it back down again is very costly,” he said on Friday.

Why is what people expect to happen to inflation so crucial? Because their expectations about inflation have a tendency to be self-fulfilling.

When businesses expect prices to keep on increasing rapidly, they keep raising their own prices. And when workers and their unions expect further rapid price rises, they keep demanding and receiving big pay rises.

This notion that, once people start expecting the present jump in inflation to persist, it becomes “ingrained” and then can’t be countered without a deep recession has been “ingrained” in the conventional wisdom of macroeconomists since the 1970s.

They call it the “wage-price spiral” – thus implying it’s always those greedy unionists who threw the first punch that started the brawl.

In the 1970s and 1980s, there was a lot of truth to that characterisation. In those days, many unions did have the industrial muscle to force employers to agree to big pay rises if they didn’t want their business seriously disrupted.

But that’s obviously not an accurate depiction of what’s happening now. The present inflationary episode has seen businesses large and small greatly increasing their prices to cover the jump in their input costs arising from pandemic-caused supply disruptions and the Ukraine war.

Although the rate of increase in wages is a couple of percentage points higher than it was, this has fallen far short of the 5 or 6 percentage-point further rise in consumer prices.

So Lowe has reversed the name of the problem to a “prices-wages spiral”. In announcing this month’s rate rise, he said that “given the importance of avoiding a prices-wages spiral, the board will continue to play close attention to both the evolution of labour costs and the price-setting behaviour of firms in the period ahead”.

Lowe admits that inflation expectations, the thing that could set off a prices-wages spiral, have not risen. “Medium-term inflation expectations remain well anchored,” but adds “it is important that this remains the case”.

If that’s his big worry, Treasury secretary Dr Steven Kennedy doesn’t share it. Last week he said bluntly that “the risk of a price and wage spiral remains low, with medium-term inflation expectations well anchored to the inflation target.

“Although measures of spare capacity in the labour market show that the market remains tight, the forecast pick-up in wages growth to around 4 per cent is consistent with the inflation target.”

So, why does Lowe remain so concerned about inflation expectations leading to a prices-wages spiral that he expects he’ll have to keep raising the official interest rate?

There must be something he’s not telling us. I think his puzzling preoccupation with inflation expectations is a cover for his real worry: oligopolistic pricing power.

Why doesn’t he want to talk about it? Well, one reason could be that the previous government has given him a board stacked with business people.

A better explanation is that he’s reluctant to admit a cause of inflation that’s not simply a matter of ensuring the demand for goods and services isn’t growing faster than their supply.

Decades of big firms taking over smaller firms and finding ways to discourage new firms from entering the industry has left many of our markets for particular products dominated by two, three or four huge companies – “oligopoly”.

The simple economic model lodged in the heads of central bankers assumes that no firm in the industry is big enough to influence the market price. But the whole point of oligopoly is for firms to become big enough to influence the prices they can charge.

When there are just a few big firms, it isn’t hard for them reach a tacit agreement to put their prices up at the same time and by a similar amount. They compete for market share, but they avoid competing on price.

To some degree, they can increase their prices even when demand isn’t strong, or keep their prices high even when demand is very weak.

I suspect what’s worrying Lowe is his fear that our big firms will be able keep raising their prices even though his higher interest rates have greatly weakened demand. If so, his only way to get inflation back to the target band will be to keep raising rates until he “crunches” the economy and forces even the big boys to pull their horns in.

It’s hard to know how much of the surge in prices we saw last year was firms using their need to pass on to customers the rise in their input costs as cover for fattening their profit margins.

We do know that Treasury has found evidence of rising profit margins – “mark-ups”, as economists say – in Australia in recent decades.

And a study by the Federal Reserve Bank of Kansas City has found that mark-ups in the US grew by 3.4 per cent in 2021.

But for Lowe (and his predecessors, and peers in other central banks) to spell all that out is to admit there’s an important dimension of inflation that’s beyond the direct control of the central banks.

If he did that, he could be asked what he’s been doing about the inflation caused by inadequate competition. He’d say competition policy was the responsibility of the Australian Competition and Consumer Commission, not the Reserve. True, but what an admission.

In truth, the only person campaigning on the need to tighten competition policy in the interests of lower inflation is the former ACCC chair, Professor Rod Sims. Has he had a shred of public support from Lowe or Kennedy? No.

Final point: what’s the most glaring case of oligopolistic pricing power in the country? The four big banks. Since the Reserve began raising interest rates, their already fat profits have soared.

Why? Because they’ve lost little time in passing the increases on to their borrowing customers, but been much slower to pass the increase through to their depositors. Has Lowe been taking them to task? No, far from it.

But his predecessors did the same – as no doubt will his successors, unless we stop leaving inflation solely to a central bank whose only tool is to fiddle with interest rates.

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Why the customer doesn't always come first

The world is a complicated place. I have no doubt that the capitalist, market-based way of running an economy delivers the best results for workers and consumers. But that doesn’t mean companies never do bad things, nor that every business always does the right thing by its customers.

The father of modern economics, Adam Smith, famously said that “it is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest”.

But, he argued, the “invisible hand” of “market forces” – the interaction of demand and supply in moving prices up and down – takes all the self-interest of businesses and the self-interest of consumers and turns them into businesses getting adequately rewarded for delivering just the right combination of goods and services to all the people in the economy.

There’s a huge amount of truth to that simple – if hard to believe – proposition. But it’s not the whole truth. One way to think of it is that, as Winston Churchill said of democracy, it’s the worst way of doing it – except for all the other ways. In this case, except for leaving all the decisions about what and how much to produce to the government.

So, to say capitalism is the best way of organising an economy isn’t to say it’s without fault. That it never does things badly.

In a speech this week, Rod Sims, the former chairman of the Australian Competition and Consumer Commission, but now a professor at the Australian National University, said that although companies regularly proclaim that they put their customers first, “companies clearly do not always have the interests of their customers in mind”.

So what are the reasons that, almost 250 years after Smith’s discovery, capitalism doesn’t always give consumers a good deal.

Sims can think of six reasons market forces don’t live up to their billing.

For a start, meeting customer needs may not be the main way companies increase their profits. Businesses are motivated to make profits and to increase those profits. But being the best at meeting the needs of customers isn’t the only way, or even the dominant way, firms succeed, Sims says.

For a firm to stay ahead of its rivals by continually improving its products and services is difficult. And eventually another firm works out how to do things better and cheaper than you.

“Commercial strategy therefore is largely about building defences against the forces of competition. To make it more difficult for other firms to develop a better product. Or, if they do, to limit their access to customers,” he says.

Another reason is that company executives are under considerable sharemarket pressure to increase short-term profits. Companies strive to grow because this attracts investors, the value of their shares rises and their top executives get bigger bonuses.

Sims says many companies set high growth targets to meet the expectations of the sharemarket. Often these targets are higher than the economy’s growth, meaning not all firms can meet or exceed market expectations.

So, in some cases, company executives see no alternative but to push the boundaries to achieve the targets they’ve been set.

That’s bad, but it becomes worse if the poor behaviour of a few causes normal competitive pressure to keep getting better than the others to reverse and become a race to the bottom.

Sims says that in well-functioning markets firms compete on their merits. Firms that offer what consumers value, displace firms that don’t. But the opposite can occur if poor behaviour goes undetected and unpunished, so it gives bad players a competitive edge.

“Firms can win customers through misrepresenting their offers and employing high-pressure selling tactics,” he says. As well as hurting consumers, such behaviour hurts rival firms, tempting them to protect their market share by employing the same questionable tactics.

Yet another problem occurs when firms see nothing wrong with what they’re doing, but their customers do. They (and economists) see nothing wrong with offering a better price – or interest rate – to new customers than they’re charging their existing customers.

But those older customers commonly react with outrage when they discover they’ve gone for years paying more than they needed to. They feel their loyalty has been abused.

Speaking of loyalty, Sims’ final explanation of why customers may be treated badly is that executives may feel their obligations to their company compel them to pursue profit to the maximum, even if their behaviour pushes too close to the boundaries of the law and isn’t the behaviour they would engage in privately.

So, what should be done about all these instances of “market failure” – where markets don’t deliver the wonderful benefits advertised by economists?

Sims has two remedies. First, as he argued strongly while boss of the competition and consumer commission, it needs stronger merger laws to help it prevent anti-competitive mergers. The courts require evidence about what will happen after a merger has occurred, but it’s hard for the commission to prove what hasn’t yet happened.

“The courts seem largely unwilling to accept commercial logic; that if you have market power you will use it. The courts can sometimes seem naive,” he says.

Second, we need a law against unfair practices, as they have in the United States, Britain and most of Europe.

“Our current laws are poorly suited to stopping behaviour ranging from online manipulation of consumers, to processors saying they will reject farm goods unless the prices agreed before the goods were shipped are now lowered.”

In the end, it’s simple. All the claims that capitalism will deliver a great deal for consumers are based on the assumption that businesses face stiff competition from other businesses to keep them in line.

But when too many markets are dominated by a few huge companies, service goes down and prices go up by more than they should.

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RBA warning: our supply-side problems have only just begun

In one of his last speeches for the year, Reserve Bank governor Dr Philip Lowe has issued a sobering warning. Even when we’ve got on top of the present inflation outbreak, the disruptions to supply we’ve struggled with this year are likely to be a recurring problem in the years ahead.

Economists think of the economy as having two sides. The supply side refers to our production of goods and services, whereas the demand side refers to our spending on those goods and services, partly for investment in new production capacity, but mainly for consumption by households.

Lowe notes that, until inflation raised its ugly head, the world had enjoyed about three decades in which there were few major “shocks” (sudden big disruptions) to the continuing production and supply of goods and services.

When something happens that disrupts supply, so that it can’t keep up with demand, prices jump – as we’ve seen this year with disruptions caused by the pandemic and its lockdowns, and with Russia’s attack on Ukraine.

What changes occurred over the three decades were mainly favourable: they involved increased supply of manufactured goods, in particular, which put gentle downward pressure on prices.

This made life easier for the world’s central banks. With the supply side behaving itself, they were able to keep their economies growing fairly steadily by using interest rates to manage demand. Put rates up to restrain spending and inflation; put rates down to encourage spending and employment.

The central banks were looking good because the one tool they have for influencing the economy – interest rates – was good for managing demand. Trouble is – and as we saw this year – managing demand is the only thing central banks and their interest rates can do.

When prices jump because of disruptions to supply, there’s nothing they can do to fix those disruptions and get supply back to keeping up with demand. All they can do is strangle demand until prices come down.

So, what’s got Lowe worried is his realisation that a lot of the problems headed our way will be shocks to supply.

“Looking forward, the supply side looks more challenging than it has been for many years” and is likely to have a bigger effect on inflation, making it jump more often.

Lowe sees four factors leading to more supply shocks. The first is “the reversal of globalisation”.

Over recent decades, international trade increased significantly relative to the size of the global economy, he says.

Production became increasingly integrated across borders, and this lowered costs and made supply very flexible. Australia was among the major beneficiaries of this.

Now, however, international trade is no longer growing faster than the global economy. “Trading blocs are emerging and there is a step back from closer integration,” he says. “Unfortunately, today barriers to trade and investment are more likely to be increased than removed.”

This will inevitably affect both the rise in standards of living and the prices of goods and services in global markets.

The second factor affecting the supply side is demographics. Until relatively recently, the working-age population of the advanced economies was steadily increasing. This was also true for China and Eastern Europe – both of which were being integrated into the global economy.

And the participation of women in the paid labour force was also rising rapidly. “The result was a substantial increase in the number of workers engaged in the global economy, and advances in technology made it easier to tap into this global labour force,” Lowe says.

So, there was a great increase in global supply. But this trend has turned and the working-age population is now declining, with the decline projected to accelerate. The proportion of the population who are either too young or too old to work is rising, meaning the supply of workers available to meet the demand for goods and services has diminished.

The third factor affecting the supply side is climate change. Over the past 20 years, the number of major floods across the world has doubled and the frequency of heatwaves and droughts has also increased.

This will keep getting worse.These extreme weather events disrupt production and so affect prices – as we know all too well in Australia. But as well as lifting fruit and vegetable prices (and meat prices after droughts break and herd rebuilding begins), extreme weather can disrupt mining production and transport and distribution.

The fourth factor affecting the supply side is related: the transition from fossil fuels to renewables. This involves junking our investment in coal mines, gas plants and power stations, and new investment in solar farms, wind farms, batteries and rooftop solar, as well as extensively rejigging the electricity network.

It’s not just that the required new capital investment will be huge, but that the transition from the old system to the new won’t happen without disruptions.

So, energy prices will be higher (to pay for the new capital investment) and more volatile when fossil-fuel supply stops before renewables supply is ready to fill the gap.

Lowe foresees the inflation rate becoming more unstable through two channels. First, shocks to supply that cause large and rapid changes in prices.

Second, the global supply curve becoming less “elastic” (less able to respond to increases in demand by quickly increasing supply) than it has been in the past decade.

Lowe says bravely that none of these developments would undermine the central banks’ ability to achieve their inflation target “on average” - that is, over a few years – though they would make the bankers’ job more complicated.

Well, maybe. As he reminds us, adverse supply shocks can have conflicting effects, increasing inflation while reducing output and employment. The Reserve can’t increase interest rates and reduce them at the same time.

As Lowe further observes, supply shocks “also have implications for other areas of economic policy”. Yes, competition policy, for instance.

My conclusion is that managing the economy can no longer be left largely to the central bankers.

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Hey RBA boomer, things have changed a lot since the 1970s

Sorry, but Reserve Bank governor Dr Philip Lowe’s call for ordinary Australians to make further sacrifice next year in his unfinished fight against “the scourge of inflation” doesn’t hold water. His crusade to save us all from a wage-price spiral is like Don Quixote tilting at windmills only he can see.

In one of his last speeches for the year, Lowe “highlighted the possibility of a wage-price spiral” in Australia. A lesson from the high inflation we experienced in the 1970s and ’80s is that “bringing inflation back down again after it becomes ingrained in people’s expectations is very costly and almost certainly involves a recession”.

He noted that this was a real risk in “a number of other advanced economies [which] are experiencing much faster rates of wages growth”.

But not to worry. “This is an area we are watching carefully.” The Reserve Bank board is “resolute in its determination to return inflation to target, and we will do what is necessary to achieve that”.

Oh. Really? Like the smartest of the business economists, I’ve been thinking that having raised the official interest rate by 3 percentage points in eight months, Lowe may have decided he’s done enough. But this tough-guy talk hints at more to come – maybe a lot more.

One thing I am pretty sure of, however. After the caning Lowe’s been given for saying repeatedly that he didn’t expect to be raising interest rates until 2024, when he does decide he has done enough, he won’t be saying so.

To leave his options open – and pacify the urgers in the financial markets who want him to do a lot more – he’ll say it’s just a pause to see how the medicine’s going down. And add something like “the board expects to increase interest rates further over the period ahead, but it is not on a pre-set course”.

One reason Lowe doesn’t have to raise rates as far as many overpaid money-market people imagine is that with real wages having fallen in recent years, and expected to keep falling, the nation’s employers are doing his job for him.

Raise mortgage interest rates or cut real wages – whichever way you do it, the result is to put the squeeze on households, to stop them spending as much (on the things the people who cut their wages are hoping to sell them – no, doesn’t make sense to me, either).

So, we’re back to Lowe’s professed fear of a wage-price spiral. The entire under-50 population must be wondering what such a thing could be. Lowe spelt it out while answering questions after his speech.

“The issue that many central banks have been worried about – and I include us in this – is [that] this period of high inflation will lead the workforce to say: ‘Well, inflation is high, I need compensation for that’.”

“And let’s say we all accepted the idea, which [has] a natural appeal: ‘inflation is 7 per cent, I should be compensated for that in my wages’. If that were to happen, what do you think inflation would be next year? Seven per cent, plus or minus.

“And then we’ve got to get compensated for that 7 per cent, and 7 per cent. . . This is what happened in the ’70s and ’80s and ... that turned out to be a disaster,” Lowe said.

“So I know it’s very difficult for people to accept the idea that wages don’t rise with inflation. And people are experiencing a decline in real wages. That’s tough. The alternative, though, is more difficult,” he added.

This is a reasonable description of how the wage-price spiral worked in the olden days. But as a plausible risk for today, it has two glaring weaknesses.

First, it assumes that if workers decide they want a 7 per cent pay rise, bosses have no choice but to hand it over. This is fantasy land.

The plain truth is that these days, workers lack the industrial muscle to force big pay rises on employers. The best-placed workers on enterprise agreements are getting rises of 3 to 4 per cent, but some are still getting rises in the twos.

The lowest-paid quarter of workers, dependent on award wage minimums, get their rises determined annually by the Fair Work Commission – but these are granted in retrospect, not prospect. This July, a handful of them got a rise of 5.2 per cent, but most got 4.6 per cent.

The bargaining power workers had in the ’70s has been reduced by more than four decades of globalisation, technological change and wage-fixing “reform”. In 1976, 52 per cent of workers were members of a union. Now it’s down to just 12.5 per cent.

Yet another reason a wage-price spiral couldn’t happen today is that most enterprise agreements run for three years. The system prohibits me from striking for a pay rise this year higher than the one I already agreed to two years ago.

The second respect in which Lowe’s fear of a wage-price spiral rising from the dead is silly is the assumption that if workers get a 7 per cent pay rise, businesses will automatically and easily put their prices up by 7 per cent. This makes sense arithmetically only if you think that wage costs constitute the whole of businesses’ costs. In truth, the Bureau of Statistics’ input-output tables say that economy-wide, wages account for only about a quarter of total input costs.

So, on average, a 7 per cent wage rise justifies a price rise of less than 2 per cent. Since business competitors would be paying much the same, you might think any firm that turned a 2 per cent cost increase into a 7 per cent price rise would be asking to be undercut by its competitors and lose its share of the market.

Of course, such an outrageous assault on the pockets of the industry’s customers would be possible if the industry was dominated by just a few big firms. They could – and have, and do – reach an unspoken agreement to each put their prices up by the same excessive amount.

It’s clear that Lowe knows a lot about how financial markets work, but not much about labour markets. But I find it hard to believe he could be so ill-informed as not to see the weaknesses in his wage-price spiral boogeyman.

The other possibility is that what’s really worrying him is a mass outbreak of oligopolistic pricing power. Getting that back under control really could take a recession.

Monetary policy (manipulating interest rates) is no cure for market power. The only answer is stronger competition policy and tougher policing by the Australian Competition and Consumer Commission. But neither the Reserve Bank nor Treasury has had much enthusiasm for this.

Much less controversial to blame inflation on greedy workers and tell the mums and dads it’s their duty to the nation to tighten their belts and lose their jobs until the problem’s solved.

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Weakening competition is adding to our inflation woes

We’ve worried a lot about inflation and its causes this year, but in one important respect the economy’s managers have yet to join the dots. The most basic economics tells us that what stops prices rising more than they should is strong competition between firms. If competition has weakened, that will be part of our inflation problem.

But is there evidence that competition is less intense than it was? Yes, lots. It was outlined by Assistant Treasurer Dr Andrew Leigh in a recent speech.

The basic model of how markets work – the one lodged in the head of almost every economist – assumes “perfect competition”.

Markets are supposed to consist of a huge number of consumers and many producers, each of them too small to have any ability to influence the price of the products they’re selling. So the price is determined purely by the interaction of producers’ supply and consumers’ demand.

Competition between these small firms is so intense that, should any one of them be so foolish as to raise their price above what all the other firms are charging, consumers would immediately cease buying their product, and they’d go out backwards.

I doubt if that was ever an accurate description of any real-world market. But even if it approximated the truth at the time economists got it so firmly fixed in their minds – the late 19th century – all the years since then have seen firms getting bigger and bigger.

So much so that many key industries today have just a handful of firms – often no more than four – accounting for well over half the industry’s sales.

This has happened thanks to a century or two of firms using improvements in technology to pursue “economies of scale”. Up to a point, the more widgets you can produce from the same factory, the lower their average cost of production.

Firms do this in the hope of increasing their profits. But the magic of markets – when they’re working properly – is that your competitors also use the new technology to cut their production costs, then undercut your price to pinch some of your share of the market.

This is the competitive process by which the benefits of scale-economies end up mainly in the hands of consumers, in the form of lower prices. This is a big part of the reason we’re all so much richer than our great-grandparents were.

The digital revolution has moved scale-economies to a new stratosphere. It costs a lot to develop a new GPS navigation program, for instance, but once you’ve done it, you can produce a million or two million copies at negligible extra cost.

So, fundamentally, the move to fewer but much bigger firms is a good thing. Except for this: the bigger a firm’s share of the market, the greater its ability to influence the prices it charges. This is a key motivation for big firms to keep taking over smaller firms.

And when markets are dominated by three or four big firms, it’s easy for them to reach an unspoken agreement to use advertising, marketing and superficial product differentiation to compete with their rivals, while avoiding undermining existing prices and profit margins by starting a price war.

Similarly, when all the big firms in an industry are hit by similar big increases the costs of their imported inputs – caused, say, by pandemic or war-related shortages of supply – it’s easy for them to reach an unspoken understanding that they will use this opportunity to fatten their profit margins by raising their prices by more than the rise in input costs justifies.

Which is just what seems to have been contributing to the huge rise in consumer prices this year – though it’s far too soon for economic researchers to have hard evidence this is happening.

What we do have, according to Leigh, is a “growing body of evidence that suggests excessive market concentration can lead to economic problems”.

“Dominant firms in a market may have less incentive to carry out research and development. They may have less incentive to produce new products. And in some cases, they may have less incentive to pay their employees fairly.

“As you can imagine, the drag on the economy only becomes stronger and deeper with each and every concentrated market,” Leigh says.

In the past decade, there has been a huge increase in the number of studies – covering the US and many other countries – confirming that markets have become more concentrated. That is, a higher share of the market held by a few big firms.

But, Leigh says, “mark-ups” – the gap between firms’ costs of production and their selling prices – are one of the most reliable indicators of “market power”. That is, power to raise their prices by more than is justified by their increased costs of production.

Australian research led by Treasury’s Jonathan Hambur finds that industry average mark-ups increased by about 6 percentage points between 2003 and 2016. This fits with figures for the advanced economies estimated in a study by the International Monetary Fund over the same period.

Hambur finds that mark-ups for the most digitally intensive firms increased by 12 percentage points, compared with 4 percentage points for all other firms.

And also that industries experiencing greater annual increase in concentration had greater annual increases in their mark-ups.

Of course, none of this should come as a great surprise to those few economists who specialise in the study of IO – industrial organisation – the way the real-world behaviour of monopolies and oligopolies differs from the way simple textbook models of perfect competition would lead us to expect.

Institutionally, the responsibility for seeking to ensure “effective competition” in our highly oligopolised economy rests with the Australian Competition and Consumer Commission. But its efforts to tighten scrutiny of company takeovers and other ways of increasing a firm’s market power have met stiff resistance from the big business lobby.

This new evidence of increasing mark-ups suggests the econocrats responsible for limiting inflation should be giving the ACCC more support.

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Labor's 'plan' to fix the economy has three big bits missing

If you think the jobs summit was stage-managed, you’re right. Anthony Albanese & Co got the tick for policy changes they’d always wanted to make. But the two top-drawer economists who addressed the summit – Professor Ross Garnaut and Danielle Wood, boss of the Grattan Institute – proposed three other vital matters for the government’s to-do list, which it had better get on with if it’s to manage the economy successfully.

Both wanted action on competition policy, immigration policy and fiscal (budget) policy. All of these could play an important role in making the economy less inflation-prone, achieving and retaining full employment, improving our productivity and ensuring workers get their fair share of the proceeds.

The major element in our inflation problem that no one dares to name – certainly not Reserve Bank governor Dr Philip Lowe who, in a long speech about the problem last week, didn’t find time to mention it – is the pricing power that our oligopolised economy gives our big businesses.

Much Treasury research has found that Australia’s businesses lack “dynamism”. To be blunt, they’re fat and lazy. Wood reminds us that lower levels of dynamism and innovation have been linked to a lack of competitive pressure in the economy.

“In competitive markets, excess profits should be dissipated over time as new and innovative competitors enter. But increasingly in Australia and elsewhere, we have seen the biggest and most profitable firms remain largely untroubled by new competitors,” she says.

“While being relaxed and comfortable may be profitable, it is not good for Australia’s long-term economic prospects.”

So, what should Labor do about it? “Making sure that Australia’s competition laws are fit for purpose is part of the response ... The former head of the Australian Competition and Consumer Commission, Rod Sims, has argued that the current merger laws are failing to adequately protect competition. His warnings should prompt serious thought,” Wood says.

Garnaut agrees. He says we have to think about the increasing role of “economic rents” – the ability to earn profits exceeding those needed to keep you in the business. “Productivity is reduced and the profit share of [national] income increased by monopoly and oligopoly,” he says.

The answer? “Rod Sims has drawn attention to the increasing role of oligopoly in the Australian economy, and the competition policy reforms that would reduce it.”

The point for the government to note is that, if it leaves big business’s pricing power unchecked, but restores the unions’ bargaining power, that will be a recipe for a more inflation-prone economy – and a Reserve Bank using high interest rates to keep the economy comatose.

Both Garnaut and Wood gave the highest priority to urging a lasting return to full employment and the many social and economic benefits it would bring, if the jobs market was always about as tight as it is now.

But, as Garnaut says, full employment is hard work for employers. “Many prefer unemployment, with easy recruitment at lower wages.”

Which helps explain why they’re so desperate to get the immigration flood gates reopened and flowing. They talk about shortages of skilled labour but, in truth, they’re just as keen to have less-skilled labour. High immigration is just one of the instruments from their toolbox they’ve been using to keep their labour costs low, including the cost of training workers.

But we can’t keep our gates shut forever, so what should the government do to open up without losing the benefits of full employment (including a strong incentive to train our own youngsters)?

Garnaut says immigration is much more likely to raise, rather than lower, average real wages if it is focused on permanent migration of people with genuinely scarce and valuable skills that are bottlenecks to valuable Australian production, and cannot be provided by training Australians.

Wood says we need to fix “out-dated” skilled migration rules. “Targeting higher-wage migrants directly for both temporary and permanent skilled migration would improve the productivity of the migration system and the Australian workforce,” she says.

Which brings us to the budget. Wood says that although our response to the pandemic may now seem to have stimulated demand more than is helpful, these pressures will dissipate, “especially if the federal government and the central bank work in tandem to address strong demand, and do what is possible to boost supply”.

That’s her nice way of saying that, if the government fails to get its budget deficit down, the Reserve Bank will take interest rates higher than it would have. And she’s right, it will.

The deficit needs to come down despite Labor’s expensive – but welcome – promise to greatly increase the wage rates of the mainly female workers in aged care and other parts of the care economy.

How can this circle be squared? To Garnaut, the answer’s obvious. If the government has to do more and pay more – including on defence – it will just have to tax more.

He reminds us that “in the face of these immense budget challenges, total and federal and state taxation revenue, as a share of gross domestic product, is 5.7 percentage points lower than the developed-country average.”

And when it comes to what more the government could tax, Garnaut has some ideas. Disruption from the Russian invasion of Ukraine has given our fossil fuel companies record profits from higher coal and gas prices, while substantially lowering living standards by greatly increasing electricity prices.

Garnaut says the government shouldn’t kid itself that leaving this disparity unchallenged wouldn’t leave deep wounds in the public’s faith in government.

Introducing a tax on these windfall profits would be one solution, but I suspect he wants something more substantive. He says a significant part of the increase in the profit share of national income in recent years has come from mining.

One response would be for mine workers to get much higher wages. But, he says, miners are already paid much more than workers in other industries. So, the appropriate public policy response is a mineral rent tax – that is, a tax on the mining companies’ excess profits – which would share the benefits with all of us.

Finally, Garnaut rebukes those economists who rely on fancy calculations to tell them how low the unemployment rate can get before we have a problem with inflation. He says this is not an output from an econometric model, it’s “an observed reality”. That is, you have to suck it and see.

“Economics is less amenable than physics to definitive mathematical analysis because it is about people, whose responses to similar phenomena change over time. We build models in our minds or computers that fit observed reality at one point in time, and reality changes. Then we have to think harder about what’s going on.”

Economics is about the behaviour of people! Who knew?

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Breaking news: unions play a central role, for good and ill

Welcome back to a tripartite world, where Labor has returned to power and its union mates are back inside the tent – and at last week’s jobs summit could be seen moving in their furniture. For those who don’t remember the 1983 glory days of Bob Hawke, Paul Keating, consensus, the Accord, and former ACTU secretary Bill Kelty as an honorary member of the cabinet, it will take some getting used to.

For those who’ve been watching only since the John Howard era, it may even seem unnatural. One of Howard’s first acts upon succeeding Hawke and Keating in 1996 was to delegitimise the unions.

He allowed the tripartite committees to lapse, and didn’t reappoint the ACTU secretary to the board of the Reserve Bank. I doubt if many even informal links between ministers and union leaders continued.

The Libs didn’t know the union bosses, and didn’t want to know ’em. They were the enemy – always had been, always would be. Big business bosses, on the other hand, would be privately consulted and were always welcome to phone up for a quiet word with the minister.

This, by the way, helps explain the Reserve Bank’s pro-business bias. Its board is loaded with business worthies - who are there to help keep the central bankers’ feet on the ground – and its extensive program of regular and formal “liaison” with key firms and industries, doesn’t include asking union leaders what they think’s happening.

If you wonder why Reserve governor Dr Philip Lowe’s remarks about wages can sometimes seem naive – even out of “boomer fantasy land” – it’s because he only ever hears the bosses’ side of the story. And I doubt if they ever shock his neoclassical socks by talking about how they exercise their market power.

It’s easy to justify the Liberals’ delegitimation of the unions by noting that, these days, only about 14 per cent of employees belong to a union. But if you find that argument persuasive, you’re revealing your ignorance of our wage-fixing institutions.

Most workers are subject to an industrial award, and there’s a union (and an employer or employer group) on one end of every award, and almost every enterprise agreement. In the Fair Work Commission’s annual wage review – which sets the wages of about a quarter of all employees – it’s the ACTU that stands against the employer groups arguing that times are tough, and they couldn’t possibly afford a rise of anything much.

So, to say the unions have what economists would call a giant “free-rider” problem – a lot of people happy to receive benefits without paying for them – is not to say they shouldn’t be given a seat at the table.

Liberals, business and their media cheer squad may be appalled by sanctification of the unions, but at least Labor’s making it clear it wants business to keep its seat at the table. It will be consulted. This too is Labor’s inheritance from the Hawke-Keating experience: to the extent possible, keep business on side.

The ACT’s second-biggest industry – lobbying – will be busier than ever. It’s third-biggest – consulting – not so much.

What all agreed at the summit is that Labor has taken over an economy with many structural problems that need fixing. Not the least of these is that the wage-bargaining system is broken.

What we learnt last week, from everything ministers said and from the 14-page “outcomes document” is that, in marked contrast to its predecessor, Labor does intend to fix things.

The whole summit, tripartite business is about giving all the key players a say in how things are fixed, giving them a heads-up on the government’s intentions, and an introduction to the minister. About winning support – or, at least, acquiescence – from as many of the powerful players as possible, to minimise the political risks of making changes.

Under Labor’s tripartism, the three parties aren’t equal. The government will, in the end, do what it decides to do. The unions start well ahead of business, because of their special relationship with a Labor government.

They have a further advantage over business: solidarity. The many unions are used to speaking with one, unified voice through the ACTU, whereas business fractures into big versus small, and rival employer groups. The unions know all about playing one business group off against another.

What business has to decide is whether it wants to stay in the government’s tent or walk out. Because, in business, pragmatism usually trumps idealism, my guess is that business will play ball for as long as Labor looks like staying in office.

After the summit ended, the ACTU’s statement said it had always “been clear that we need to get wages moving and increase skills and training for local workers in order for unions to support lifting skilled migration levels. We welcome that this summit has delivered those commitments.”

It was all a talk fest? No, a deal was done and that quote reveals just what the deal was. However, a big part of the business side didn’t support fixing the wage-bargaining system by returning to “multi-employer” bargaining.

What’s clear is that the government will be pressing on with some form of multi-employer bargaining. What isn’t yet clear is what that form will be. Until it’s finalised, business will be busy inside the tent pushing for whatever modifications it can get.

With Labor back in power and the unions back walking the halls of power, it’s important to understand the relationship between the two arms of the “labour movement”. Whereas the relationship between the Libs and business is quite informal, the relationship between Labor and the unions is highly formal. They’re not mates, they’re close rellos.

Historically, the unions set up the Labor Party to be their political arm. To this day, those unions that pay dues to the Labor Party still wield considerable influence over it and the members of the federal parliamentary caucus.

Labor parliamentarians are affiliated with particular unions, which gives some of the bigger unions considerable influence over preselections, on who gets to stay leader of the party, and on certain policy matters.

When Labor is in government, businesses in certain industries use their unions to get to the government. This explains why Labor governments haven’t done as much as they should to tighten up our competition law.

And whereas Howard left the Libs with a visceral hatred of industry super funds, Labor’s links with the unions – and the unions’ links with the ticket-clippers of the super industry – mean it can’t always be trusted to favour the interests of super members over super managers.

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Don't expect great productivity if we give business an easy ride

An unwritten rule in the economic debate is that you can say whatever you like about the failures of governments – Labor or Liberal; federal or state – but you must never, ever criticise the performance of business. Maybe that’s one reason we’re getting so little productivity improvement these days.

One reason it’s unwise to criticise big business is that it’s got a lot of power and money. It can well defend itself but, in any case, but there’s never any shortage of experts happy to fly to its defence, in hope of a reward.

But the other reason is the pro-business bias built into the standard demand-and-supply, “neoclassical” model burnt into the brains of economists. It rests on the assumption that market economies are self-correcting – “equilibrating” - and so work best when you follow the maxim “laissez-faire” – leave things alone.

So if markets don’t seem to be going well, the likeliest explanation is that intervention by governments has stuffed them up. Business people always respond rationally to the incentives that governments create, so if what business is doing isn’t helpful, it must be the government’s fault.

In theory, economists know about the possibility of “market failure”, but many believe that, in practice, such failures are rare, or of little consequence.

All this explains why almost all discussion of our poor productivity performance assumes it must be something the government’s doing wrong, which needs “reforming”. You’ll see this mentality on display at next week’s jobs and skills summit.

Which is surprising when you remember that, for the most part, productivity improvement – producing more outputs of goods and services from the same or fewer inputs of raw materials, labour and physical capital – occurs inside the premises of businesses, big or small.

Fortunately, one person who understands this is the new assistant treasurer, Dr Andrew Leigh, a former economics professor, who this week used the Fred Gruen lecture at the Australian National University to outline recent Treasury research on the “dynamism” of Australian businesses – how good they are at improving their performance over time.

The news is not encouraging. One indicator of dynamism is job mobility. When workers switch from low-productivity to high-productivity firms, they earn a higher wage and make the economy more efficient.

The proportion of workers who started a new job in the past quarter fell from 8.7 per cent in the early 2000s to 7.3 per cent in the decade to the end of 2019.

Another indicator of dynamism is the “start-up rate” – the number of new companies being set up each year. It’s gone from 13 per cent in 2006 to 11 per cent in 2019.

Over the same period, the number of old companies closing fell from 10 per cent to 8 per cent. So our firms are living longer and getting older.

The neoclassical model assumes a high degree of competition between firms. It’s the pressure from competition that encourages firms to improve the quality of their products and offer an attractive price. It spurs firms to develop new products.

Competition encourages firms to think of new ways to produce their products, run their businesses and use their staff more effectively, Leigh says.

“In competitive industries, companies are forced to ask themselves what they need to do to win market share from their rivals. That might lead to more research and development, the importation of good ideas from overseas, or adopting clever approaches from other industries.

“Customers benefit from this, but so too does the whole economy. Competition creates the incentive for companies to boost productivity,” he says.

As Leigh notes, the opposite to competition, monopoly, is far less attractive. “Monopolists tend to charge higher prices and offer worse products and services. They might opt to cut back on research, preferring to invest in ‘moats’ to keep the competition out.

“If they have plenty of cash on hand, they might figure that, if a rival does emerge, they can simply buy them out and maintain their market dominance. Monopoly [economic] rents lead to higher profits – and higher prices.”

Taken literally, “monopoly” means just one seller, but economists use the word more broadly to refer to just a few big firms - “duopoly” or, more commonly, “oligopoly”.

One indicator of the degree of “market power” – aka pricing power – is how much of a market is controlled by a few big firms. At the start of this century, the market share of the largest four firms in an industry averaged 41 per cent. By 2018-19, it had risen to 43 per cent. So across the economy, from baby food to beer, the top four firms hold a high and growing share of the market.

And the problem’s even greater when you remember that the rival firms often have large shareholders in common. For instance, the largest shareholders of the Commonwealth Bank are Vanguard and Blackrock, which are also the largest shareholders of the three other big banks.

But the strongest sign of lack of competition is the size of a company’s “mark-up” – the price it charges for its product, relative to its marginal cost of production. In the textbook, these mark-ups are wafer thin.

Treasury estimates that the average mark-up increased by about 6 per cent over the 13 years to 2016-17. This fits with the trend in other rich economies. And the increase in mark-ups has occurred across entire industries, not just the market leaders.

It seems that rising market power has reduced the rate at which labour flows to its most productive use, which in turn has lowered the rate of growth in the productivity of labour by 0.1 percentage points a year, according to Leigh’s rough calculations.

If so, this would explain about a fifth of the slowdown in productivity improvement since 2012. Lax regulation of mergers and takeovers has allowed too many of our big businesses to get fat and lazy, even while raising their prices and profits. But don’t tell anyone I said so.

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Our hidden inflation problem: business has too much pricing power

Why is Reserve Bank governor Dr Philip Lowe so worried about getting inflation down when so much of the rise in prices comes from foreign supply constraints that will eventually go away, and so much of the rise won’t be passed on to workers in higher wages?

Because what he can’t admit is that inflation won’t fall back to the target range of 2 to 3 per cent until the nation’s businesses decide to moderate their price rises. And they’re not likely to do that until those rises reach the point where they’re driving away customers.

It’s said that using monetary policy (higher interest rates) to control inflation is a “blunt instrument”. The only way to discourage businesses from raising their prices is to get to their customers’ wallets - by cutting real wages, increasing mortgage payments and having falling house prices make them feel less wealthy.

When explaining problems in the economy, economists use two favourite analytical tools. First, determine how much of the problem is coming from the supply (production) side of the economy, and how much from the demand (spending) side.

Second, determine whether the problem is “cyclical” or “structural”. That is, has it been caused by the temporary ups and downs of the business cycle, or by longer-lasting changes in the economy’s structure – the way it works.

I’ve argued that most of the surge in prices has come from the supply side: a horrible coincidence of supply disruptions caused by the pandemic, the Ukraine war, and even climate change.

This matters because monetary policy can do nothing to fix disruptions to supply. All it can ever do is batter down demand.

It’s true, however, that this main, supply-side problem has been worsened by the effect of strong, government-stimulated demand for goods as services.

As for the cyclical-versus-structural distinction, it’s relevant because, as Lowe never tires of reminding us, monetary policy is capable of dealing only with cyclical problems. Its role is to smooth the ups and downs in demand as the economy moves through the business cycle.

But here’s the problem: higher interest rates aren’t working to reduce inflation the way they used to because of changes in the structure of the economy.

In particular, employees and their unions now have less power to insist on wage rises sufficient to keep up with price rises than they did when last we had a big inflation problem. But big business now has more power to raise its prices.

Partly because globalisation has moved much manufacturing from the high-wage advanced economies to China and other low-wage economies, and partly because of the decentralisation and deregulation of wage-fixing and the decline in union membership, most workers pretty much have to accept whatever inadequate pay rise their chief executive (or premier) chooses to give them.

This is why all the concern about inflation expectations becoming “unanchored” is so silly. Businesses have the power to act on their expectations of higher inflation, but workers no longer do.

This is why the rate of unemployment can fall far below what economists, using data going back decades, estimate to be the NAIRU - “non-accelerating-inflation” rate of unemployment - without wage inflation accelerating.

When thinking about inflation, macroeconomists – including Lowe, I suspect - often assume our markets are competitive, and that the markets for all goods and services are equally competitive.

But as Rod Sims, former chair of the Australian Competition and Consumer Commission, and now a professor at the Australian National University, has written, markets in Australia are generally far from strongly competitive.

“Many sectors ... are dominated by just a few firms – think beer, groceries, energy and telecommunications retailing, resources, elements of the digital economy, banking and many others,” Sims says.

“This means the dominant firms have some degree of market power. That is, they can set prices at higher levels knowing competitors are unlikely to undercut them and take market share from them.

“When there is high inflation, dominant firms often realise they can increase prices above any cost rises because consumers will be more accepting of this. They will often do this subtly over time.”

In concentrated markets, firms can also easily see the effects on their few competitors, and they can watch and follow each other’s behaviour. They are confident that none will break ranks on price rises because there are benefits to be had by all.

Firms with market and pricing power are also less likely to restrain prices in response to interest rate rises, Sims says. This is because it’s not competition, but dominant-firm behaviour, that’s driving pricing decisions.

As well, market power is usually associated with reduced production capacity. How often do we see reductions in combined capacity following a merger of two competitors? When demand increases, there’s then less capacity available to serve it, so we see prices rise more than they otherwise would have.

What all this means is that it may take longer for interest rates to work to slow inflation, so patience may be needed rather than further increases. And, Sims says, there could be a role for publicly exposing high margins, to put pressure on to reduce them.

Another point he makes is that this inflation owes much to price shocks in the key, highly regulated gas and electricity industries. In these cases, the best answer is to make their regulation more anti-inflationary, not just jack up interest rates further.

The micro-economic reforms of the Hawke-Keating government have made our economy much less inflation-prone than it was in the days when inflation was last a major problem.

Meanwhile, however, we’ve allowed the pricing power of big firms to grow as successive governments of both colours have resisted pressure from people like Sims to tighten our merger law, and state governments have maximised the sale price of their electricity businesses by selling them to business interests intent on turning the national electricity market into a three-firm vertically integrated oligopoly. Well done, guys.

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Perrottet's bold re-election bid: the world's first teal budget

A budget can tell you a lot about the government that produced it, especially a pre-election budget.

This one reveals a reformist Premier anxious to persuade us his government has reformed itself. It’s your classic, all-singing, all-dancing pre-election affair, offering increased government spending on 101 different things.

In his effort to get re-elected, Dominic Perrottet has left no dollar unturned. Enjoy, enjoy.

But recent lamentations in Canberra remind me to remind you: whoever wins the state election in March, next year’s budget won’t be nearly so jolly. If there’s bad news in the offing, that’s when we’ll get it.

For a government going on 12 years old and up to its fourth premier, this budget should be the Coalition’s swansong. But Perrottet wants us to see him as new, young, energetic and reforming.

On the face of it, proof of his reforming zeal is his controversial plan to press on with replacing conveyancing duty with an annual property tax, despite Canberra’s lack of enthusiasm for helping to fund the loss of revenue during the transition.

Most economists would loudly applaud such reform. On close examination, however, the budget’s first stage doesn’t add up to much.

Even so, let’s not forget that the desire to make their people’s lives radically better has become almost non-existent among today’s self-interested politicians.

Perrottet wants a return to co-operative federalism, and will happily work with a Labor Victorian premier and Labor prime minister to achieve it.

And the reform doesn’t stop there. This pre-election budget is also the first post-election budget following the crushing defeat of the Morrison federal government. The NSW Liberal Party, with the least to learn from Scott Morrison’s many failings, is also the one that’s learnt most.

Genuine action on climate change, measures to improve the treatment of women in the workplace and the home, promoting co-operation rather than conflict and division, increased spending on early education, childcare and hospitals, the educated talking to the educated, Perrottet’s rejection of the pork barrelling condoned by his predecessor – this budget has everything.

I give you ... Australia’s first teal budget.

Much of the credit needs to be shared with the new Treasurer, Matt Kean. He is a reforming Treasurer – with many of his predecessors’ mistakes needing reform. This budget is mercifully free of the funny-money deals that blighted so many previous efforts.

The spirit of positivity that pervades the Treasurer’s fiscal rhetoric also infects his confidence that the budget will be back to surplus in a year or three, and the debt will one day stop growing. Should this optimism prove misplaced, there’s always scope for adjustment after the election.

The government is rightly proud of all it’s done building new metros, light rail and expressways. But the Coalition’s original desire to get on with a hugely expensive transport infrastructure program while limiting the state’s debt and preserving its triple-A credit rating, led it into crazy arrangements to hide much of the debt by, for example, paying businesses such as Transurban over-the-odds to do the borrowing for it.

Now Sydney, much more than any other city, is girdled by a maze of private tollways, most with a licence to whack up the tolls quarterly or annually by a minimum of 4 per cent a year. What was that about fighting inflation and the cost of living?

This was always a way of keeping official debt down by shifting the cost onto the motorists of present and future decades.

This ill-considered mess has proved so costly to people in outer-suburban electorates that the latest “reform” is for taxpayers to subsidise the worst-affected motorists – and thereby the excessive profits granted to the tollway companies.

Another false economy was to fatten the sale price of privatised ports and electricity companies by attaching to them the right for the new owner to increase prices and profitability. This has played a small part in all the trouble we’re having now making the National Electricity Market work for the benefit of users rather than big business.

In my home town, a formerly secret deal to enhance the sale price of Port Botany is effectively preventing the Port of Newcastle from responding to the looming decline of the coal export trade by setting up a container terminal.

And all that’s before you get to the creative accounting madness of transferring the state’s railways to the still-government owned Transport Asset Holding Entity.

Perrottet, who was up to his neck in that trickery, seems to be making a better fist of Premier than treasurer. And Kean seems a better Treasurer than his many Coalition predecessors. But will that be enough to cover all the missteps of the past?

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