Productivity is magical, but don't forget the side effects

Something we’ve had to relearn in this annus horribilis is that the state governments still play a big part in the daily working of the economy. Another thing we’ve realised is that the Productivity Commission is so important that some of the states are setting up their own versions.

When you put the word “productivity” into the name of a government agency, you guarantee it will spend a lot of its time explaining what productivity is – a lot of people think it’s a high-sounding word for production; others that it means we need to work harder – and why it’s the closest economics comes to magic.

Earlier this year the NSW Productivity Commission issued a green paper that began with the best sales job for the concept I’ve seen. Its title said it all: Productivity drives prosperity.

Its simple definition of productivity is that it “measures how well we do with what we have. Productivity is the most important tool we have for improving our economic [I’d prefer to say our material] wellbeing,” it says.

“Our productivity grows as we learn how to produce more and better goods and services using less effort and resources. It is the main driver of improvements in welfare and overall [material] living standards.

“From decade to decade, productivity growth arguably matters more than any other number in an economy . . . Growth in productivity is the very essence of economic progress. It has given us the rich-world living standards we so enjoy.”

Productivity improvement itself is driven by increases in our stock of knowledge and expertise (or “human capital stock”) and by investment in physical capital (“physical capital stock”).

But by far the biggest long-term driver of productivity is the stock of advances known as “technological innovation” – a term that covers everything from new medicines to industrial machinery to global positioning systems.

Technology’s contribution to overall productivity growth has been estimated at 80 per cent, the paper says.

“Our future prosperity depends upon how well we do at growing more productive – how smart we are in organising ourselves, investing in people and technology, getting more out of both our physical and human potential.”

The (real) Productivity Commission has pointed out that on average it takes five days for an Australian worker to produce what a US worker can produce in four. (That’s not necessarily because the Yanks work harder than we do, but because they have fancier equipment to work with, and better organised offices and factories – not to mention greater economies of scale.)

The paper notes that productivity improvement hinges on people’s ability to change. “Unwelcome as it has been, the COVID-19 episode has shown that when we need to, we can change more rapidly than we thought. There is no reason we can’t do the same to achieve greater productivity and raise our future incomes.”

Technological innovation is the process of creating something valuable through a new idea. You may think that new technology destroys jobs – as the move to renewable energy is threatening the prospects of jobs in coal mining – but, if you take a wider view, you see that it actually moves jobs from one part of the economy to another and, because this makes our production more valuable, increases our real income and spending and so ends up increasing total employment.

“All through history,” the report adds, “[technological innovation] has been a huge source of new jobs, from medical technology to web design to solar panel installation. And as these new roles are created and filled, they in turn create new spending power that boosts demand for everything from buildings to home-delivered food.

But the thing I liked best about the NSW Productivity Commission’s sales pitch was the examples it quoted of how technology-driven productivity has improved our living standards.

Take, medicine. “The French king Louis XV was perhaps the world’s richest human being in 1774 – yet the healthcare of the day could not save him from smallpox. Today’s healthcare saves us from far worse conditions every day at affordable cost.”

Or farming. “In 1789, former burglar James Ruse produced [Australia’s] first successful grain harvest on a 12-hectare farm at Rose Hill. Today, the average NSW broadacre property is 2700 hectares and produced far more on every hectare, often with no more people.”

Or (pre-pandemic) travel. About “67 years after the invention of powered flight, in 1970, a Sydney-to-London return flight cost $4600, equivalent to more than $50,000 in today’s terms. Today, we can purchase that flight for less than $1400 – less than one-30th of its 1970 price.”

Or communications. “Australia’s first hand-held mobile call was made at the Sydney Opera House in February 1987 on a brick-like device costing $4000 ($10,000 in today’s terms). Today we can buy a new smartphone for just $150, and it has capabilities barely dreamt of a third of a century ago.”

There are just two points I need add. The first is that there’s a reason we’re getting so many glowing testimonials to the great benefits of productivity improvement: for the past decade, neither we nor the other rich countries have been seeing nearly as much improvement as we’ve been used to.

Second, economists, econocrats and business people have been used to talking about the economy in isolation from the natural environment in which it exists and upon which it depends, and defining “economic wellbeing” as though it’s unaffected by all the damage our economic activity does to the environment.

As each month passes, this not-my-department categorisation of “the economy” is becoming increasingly incongruous, misleading and “what planet are you guys living on?”.

What’s more, the growing evidence that all this year’s “social distancing” is having significant adverse effects on people’s mental health is a reminder we should stop assuming that ever-faster and more complicated economic life is causing no “negative externalities” for our mental wellbeing.

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Treasury chief warns big changes are on the way

When finally the pandemic has become just a bad memory, we’ll see it has left big changes in the way the macro economy is managed and the way we work and spend. Whether that leaves us better or worse off we’ve yet to discover.

That’s the conclusion I draw from Treasury Secretary Dr Steven Kennedy’s (online) post-budget speech to the Australian Business Economists on Thursday, the restoration of a tradition going back to the 1990s.

Kennedy observes that, although “fiscal policy” (changes in government spending and taxing) has always responded to large shocks such as recessions, for the past 30 years the accepted wisdom in advanced economies has been that the preferred tool for stabilising the ups and downs in demand is “monetary policy” (changes in interest rates by the central bank), leaving fiscal policy to focus on structural and sustainability (levels of public debt) issues.

This mix of policy roles was preferred because central banks could make timely decisions, using an appropriately nimble instrument – the official interest rate. Interest rates, it was considered, could help manage demand without having much effect on the allocation of resources (the shape of the economy) in the long-run, Kennedy says.

In previous downturns, monetary policy played a major part in helping to get the economy moving. In response to the 1990s recession, Kennedy reminds us, the Reserve Bank cut the official interest rate by more than 10 percentage points. In response to the global financial crisis of 2008-09, it cut rates by more than 4 percentage points.

By now, however, the Reserve has run out of room. In its response to the coronacession, it cut the rate by 0.5 percentage points to 0.25 per cent. This week it squeezed out another cut of 0.15 percentage points and went further in “unconventional” monetary policy measures. That is, printing money.

Why so little room? Interest rates are down to unprecedented lows partly because, as I wrote last week, the rate of inflation has been falling for the past 30 years.

But Kennedy explains the other reason: the “natural” or “neutral” interest rate has been “steadily falling globally over the past 40 years”. The neutral interest rate is the real official rate when monetary policy is neither expansionary nor contractionary.

(Note that word “real”. Conceptually, nominal interest rates have two parts: the bit that’s just the lenders’ compensation for expected inflation, and the “real” bit that’s the lenders’ reward for giving borrowers the temporary use of their money.)

“The declining neutral rate is due to [global] structural developments that drive up savings relative to the willingness of households and firms to borrow and invest,” Kennedy says.

“While the academic research is not settled on the relative importance of different structural drivers, it is likely due to some combination of population ageing, the productivity slowdown and lower preferences for risk among investors,” he says.

Because this is a “structural” (long-term) rather than “cyclical” (short-term) development, “a number of central banks have suggested that interest rates will not rise for many years”.

Kennedy says the size and speed of the shock from the pandemic necessitated a large fiscal (budgetary) response. This would have been true even if a large response from conventional monetary policy had been available – which it no longer was.

Monetary policy is a one-trick pony. It can make it cheaper or dearer to borrow, and that’s it. As we saw with the early measures – particularly the JobKeeper wage subsidy and the temporary supplement to the JobSeeker dole payment – fiscal policy can be targeted to problem areas. “Monetary policy cannot replace incomes or tie workers to jobs,” he says.

So the move from monetary policy to the primacy of fiscal policy is not only unavoidable, it has advantages.

Since the onset of the pandemic, the federal government has provided $257 billion in direct economic support over several years, which is equivalent to 13 per cent of last financial year’s nominal gross domestic product. That compares with the $72 billion the feds provided in economic stimulus during the global financial crisis, or 6 per cent of GDP in 2008-09.

Kennedy notes that fiscal policy is about stabilising the economy’s rate of growth over the short term; it can’t increase economic growth over the medium to long-term. According to neo-classical theory, that’s determined by the Three Ps – growth in population, participation in the labour force, and productivity.

But whereas over the 10 years to 2004-05 our rate of improvement in “multi-factor” productivity averaged 1.4 per cent a year, over the five years prior to the pandemic it averaged half that, 0.7 per cent.

There are many suggested causes for this slowdown (which can also be observed in the rest of the rich world). Treasury research has highlighted signs of reduced “dynamism” (ability to change over time), such as low rates of new firms starting up, fewer workers switching jobs, slower adoption of the latest technology, and fewer workers moving from low-productivity to high-productivity firms.

Kennedy says it’s not clear how the pandemic will affect Australia’s long-run rate of improvement in productivity. But it has the potential to cause some large structural changes in the economy. We’ve seen the way it has forced businesses to innovate.

“Necessity is a great ramrod for breaking down the barriers to technological adoption,” he says.

Remote working is one example. In September, almost a third of workers worked from home most days. If this continues it could have “significant implications for transport infrastructure planning and for the functioning of CBDs”.

An official survey in September found that 36 per cent of businesses had changed the way products or services were provided to customers. The ability to pivot displayed by many firms indicates potential for innovation and adaptation.

On the other hand, there’s a risk that closures among smaller firms will lead to even more market concentration and slower productivity growth. Let’s hope not.

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Productivity problem? Start at the bottom, not the top

Whenever we’re told we’re not achieving much improvement in our productivity, a lot of people assume it must be something the government’s done – or more likely, failed to do. Such as? Isn’t it obvious? Failed to cut the tax on companies and high income-earners.

But though the national rate of productivity improvement is merely the sum of the performances of all the industries that make up the economy, no one ever imagines the problem might be something the nation’s businesses have been failing to do.

This, however, is where a lot of research is pointing, as summarised by the Labor shadow minister and former economics professor, Dr Andrew Leigh, in a recent speech. He starts by explaining that productivity measures how efficiently the economy turns labour and capital into goods and services.

"Last year, Treasury’s Megan Quinn revealed that researchers in her department, led by Dan Andrews, had been investing in a new analysis that links together workers and firms, and delving into fresh data about the dynamics of the Australian economy," he says.

"Since 2002, Quinn showed, the most productive Australian firms (the top 5 per cent) had not kept pace with the most productive firms globally. In fact, Australia’s 'productivity frontier' has slipped back by about one-third. The best of 'Made in Australia' hasn’t kept pace with the best of 'Made in Germany', 'Made in the Netherlands' or even 'Made in America'."

And then there’s the other 95 per cent. In the past two decades, their output per hour worked has barely risen. So 19 out of 20 Australian firms don’t produce much more per hour than they did when Sydney hosted the Olympics.

What’s going wrong? "Part of the problem is that many firms aren’t investing in new technologies," Leigh says. "Less than half have invested in data analytics or intelligent software systems. Only three in five have invested in cyber security, making them vulnerable to hacking and ransomware attacks.

"It’s not just that companies aren’t investing simply in technology – they’re not investing in anything at all." In the Productivity Commission’s regular report, it measures how the amount of capital equipment per worker has increased, a process known as "capital deepening".

The commission has had to invent a new term to describe what happened last financial year – "capital shallowing". For the first time ever, the amount of capital per worker went backwards. "Given that capital deepening has accounted for about three-quarters of labour productivity growth, this is frightening," Leigh says. (To which Scott Morrison might well respond: do I look frightened?)

Across the economy, businesses are cutting back on research and development and investing less in good management. Just 8 per cent of our firms say they produce innovations that are new to the world, down from 11 per cent in 2013.

A Productivity Commission study has found that half the slowdown in productivity improvement in the market economy in recent years is accounted for by manufacturing. A separate survey of management practices in manufacturing firms found that Australia’s managers rank below those in Canada, Sweden, Japan, Germany and the US.

Leigh argues that newborn firms are as critical to an economy as newborn babies are to a society’s demography, bringing fresh approaches, shaking up existing industries, and offering new opportunities to workers.

Yet our new-business creation rate isn’t accelerating, it seems to be stopping. Defining new businesses as those that employ at least one worker, Treasury estimates that the new-business formation rate in the early 2000s was 14 per cent a year. Now it’s down to 11 per cent a year.

"Another sign that the economy may be stagnating comes from figures on job-switching," Leigh says. "Workers who switch jobs typically experience a significant pay increase. In the early 2000s the rate of job switching was 11 per cent of employees a year. Now it’s down to 8 per cent. And "Treasury’s analysis finds that a drop of one percentage point in the job-switching rate is associated with a 0.5 percentage point drop in wage growth across the economy".

The drop we’ve experienced is "not the fault of employees: there are simply fewer good opportunities available. According to Treasury’s analysis, much of the drop in job-switching is because workers are less likely to transition from mature firms to young firms. With fewer start-up firms, it stands to reason that there are fewer start-up jobs."

It’s all pretty dismal – and, of course, all the fault of the government. But I know just the reform we need to fix the problem. Morrison should offer chief executives of ASX200 companies a cut in their tax rate, provided they can show they were too busy during the financial year sticking to their knitting to attend any meetings of the Australian Business Council called to discuss lobbying the government for favours.

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Don’t forget: we all benefit from the magic of capitalism

The human capacity for adaptation – our ability to soon get used to our changed circumstances – is one of our great strengths. It means we can suffer a major misfortune – the death of a spouse, divorce, loss of a limb – and yet eventually get back to being pretty much as happy as we were.

But this pillar of human resilience has a big downside. It means when good things happen to us – even things we’ve long strived for – we soon stop being gratified and grateful, and within days or weeks start taking our advances for granted, part of the status quo.

It’s this adaptability that keeps many of us caught on what psychologists call the “hedonic treadmill”. The new house we moved to a few months back is fine, but now we really need a new car. I’ve got more clothes at home in the wardrobe than I can wear, but I’d really get a kick from buying a new jacket. All I need is a bit more money and then I’ll be happy.

With the media continually reminding us of all that’s wrong with our economy – weak wages growth, still-high unemployment and underemployment, a government not game to tackle climate change – it’s too easy to take for granted all that’s right with it. We’re the richest generation of Australians who’ve ever lived, and we shouldn’t forget it (especially when our politicians try to tell us we can’t afford to help the poor).

Enter Michael Brennan, chair of the Productivity Commission. If you think Reserve Bank governor Dr Philip Lowe is our only top econocrat who sees our glass as two-thirds full, you need to meet Brennan. He’s on a mission to show us how well we’re doing thanks to . . . productivity improvement.

In his speeches in recent months, Brennan has noted that it’s “been the great fortune of humankind, particularly in . . . the developed economies, to have experienced rapid growth in incomes and living standards over the last 200 years”.

Before and after Federation in 1901, we were the richest country in the world – thanks to our “wealth for toil”, mainly in the form of gold and wool. As the American Century got under way, we lost that lead.

In the period after World War II, our real gross domestic product per person went from being nearly $6000 a year above the rich-country average in 1950, to below the average in 1990.

But we began opening up and modernising our economy in the mid-1980s. Over the past 30 years our real GDP per person – that is, after allowing for inflation and population growth – has out-performed all of the G7 economies of North America, Europe and Japan, and our incomes have risen back to being well above the rich-world average. (Take a bow, Paul Keating.)

We have one of the strongest budgetary positions (which remains true even if we don’t make it “back in the black” this year) and the most progressive tax-and-transfers system in the Organisation for Economic Co-operation and Development.

Contrary to any impression you may have gained, our inequality of income hasn’t worsened a lot over the past 30 years. And, although our household wealth (assets minus debts) is a lot more unequal than our incomes, it’s low by rich-world standards.

Brennan says our life expectancy is high, for spending on healthcare that’s modest as a share of GDP. We face neither the budgetary and demographic problems of the Eurozone, the inequality of the US or the stagnation of Japan.

Average incomes in Australia today are seven times higher than they were in 1901. Environmentalists should note is that only some of this growth has come from increased exploitation of natural resources and damage to the environment (which is certainly something we need to correct).

No, the great majority of this growth has come from the magic of the capitalist system: improved productivity (the very magic Brennan is paid to promote). The average worker today can produce hugely more value in goods or services per hour than the average worker in 1901. Why? Because we’re healthier, better educated and more highly skilled, and we’re not only given far more equipment to work with, but those machines can do tricks that were never dreamt of a hundred years ago. And factories and offices are more efficiently organised.

That’s the capitalist magic of productivity improvement.

Brennan’s party trick is to demonstrate what a seven-times higher real income means in concrete terms. He calculates, for instance, that whereas the average employee had to work 22 hours to rent the average Australian three-bedroom house for a week in 1901, today it takes 12 hours (and it’s a much better house).

The cost of a bicycle – which in those days was the main form of transport – has dropped from 527 hours of work to less than eight hours. The cost of a kilo of rump steak has gone from 143 minutes work to 38; a loaf of bread from 20 minutes to six; a litre of milk from 31 minutes to just over two.

It’s noteworthy that whereas the wage cost of manufactured goods has fallen hugely, the wage cost of services hasn’t – because the wage of the person delivering the service has gone up with the wage of the person buying it.

But Brennan says the point of economic progress isn't just having more and cheaper "stuff", but also having qualitatively different stuff thanks to innovation and technology. That includes all the stuff we take for granted around the home - television, refrigeration, indoor plumbing and airconditioning - not to mention cars, air travel, the internet and smartphones. Then there's statins, the polio vaccine, a much lower likelihood of dying in childbirth, and antibiotics, which can be bought with as little as a quarter of an hour's work.

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No progress on wages, but we’re getting a better handle on why

In days of yore, workers used to say: another day, another dollar. These days they’d be more inclined to say: another quarter, another sign that wages are stuck in the slow lane. But why is wage growth so weak? This week we got some clues from the Productivity Commission.

We also learnt from the Australian Bureau of Statistics that, as measured by the wage price index, wages rose by 0.5 per cent in the three months to the end of December, and by just 2.2 per cent over the year - pretty much the same rate as for the past two years.

It compares with the rise in consumer prices over the year of just 1.8 per cent. If prices aren’t rising by much, it’s hardly surprising that wages aren’t either. But we got used to wages growing by a percentage point or so per year faster than consumer prices and, as you see, last year they grew only 0.4 percentage points faster.

It’s this weak “real” wage growth that’s puzzling and worrying economists and p---ing off workers. Real wages have been weak for six or seven years.

So why has real wage growth been so much slower than we were used to until 2012-13? Various people, with various axes to grind, have offered rival explanations – none of which they’ve been able to prove.

One argument is that real wage growth is weak for the simple and obvious reason that the annual improvement in the productivity of labour (output of goods and services per hour worked) has also been weak.

It’s true that labour productivity has been improving at a much slower annual rate in recent years. It’s true, too, that there’s long been a strong medium-term correlation between the rate of real wage growth and the rate of labour productivity improvement.

When the two grow at pretty much the same rate, workers gain their share of the benefits from their greater productivity, and do so without causing higher inflation. But this hasn’t seemed adequate to fully explain the problem.

Another explanation the Reserve Bank has fallen back on as its forecasts of stronger wage growth have failed to come to pass is that there’s a lot of spare capacity in the labour market (high unemployment and underemployment) which has allowed employers to hire all the workers they’ve needed without having to bid up wages. Obviously true, but never been a problem at other times of less-than-full employment.

For their part, the unions are in no doubt why wage growth has been weak: the labour market "reforms" of the Howard government have weakened the workers’ ability to bargain for decent pay rises, including by reducing access to enterprise bargaining.

But this week the Productivity Commission included in its regular update on our productivity performance a purely numerical analysis of the reasons real wage growth has been weak since 2012-13. It compared the strong growth in real wages in the economy’s “market sector” (16 of the economy’s 19 industries, excluding public administration, education and training, and health care and social assistance) during the 18 years to 2012-13 with the weak growth over the following six years.

The study found that about half the slowdown in real wage growth could be explained by the slower rate of improvement in labour productivity. Turns out the weaker productivity performance was fully explained by just three industries: manufacturing (half), agriculture and utilities (about a quarter each).

A further quarter of the slowdown in real wage growth is explained by the effects and after-effects of the resources boom. Although the economists’ conventional wisdom says real wages should grow in line with the productivity of labour, this implicitly assumes the country’s “terms of trade” (the prices we get for our exports relative to the prices we pay for our imports) are unchanged.

But, being a major exporter of rural and mineral commodities, that assumption often doesn’t hold for Australia. The resources boom that ran for a decade from about 2003 saw a huge increase in the prices we got for our exports of coal and iron ore. This, in turn, pushed the value of our dollar up to a peak of about $US1.10, which made our imports of goods and services (including overseas holidays) much cheaper.

This, of course, was reflected in the consumer price index. When you use these “consumer prices” to measure the growth in workers’ real wages before 2012-13, you find they grew by a lot more than justified by the improvement in productivity.

In the period after 2012-13, however, export prices fell back a fair way and so did the dollar, making imported goods and services harder for consumers to afford. So there’s been a sort of correction in which real wages have grown by less than the improvement in labour productivity would have suggested they should. Some good news: this is a one-time correction that shouldn’t continue.

Finally, the study finds that a further fifth of the slowdown in real wage growth is explained by an increase in the profits share of national income and thus an equivalent decline in the wages share.

Almost three-quarters of the increase in the profits share is also explained by the resources boom. It involved a massive injection of financial capital (mainly by big foreign mining companies, such as BHP) to hugely increase the size of our mining industry – which, as the central Queenslanders lusting after Adani will one day find out, uses a lot of big machines and very few workers. Naturally, the suppliers of that capital expect a return on their investment.

But harder to explain and defend is the study’s finding that more than a quarter of the increase in the profits share is accounted for by the greater profitability of the finance and insurance sector. Think greedy bankers, but also the ever-growing pile of compulsory superannuation money and the anonymous army of financial-types who find ways to take an annual bite out of your savings.

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Lucky Country has lost its dynamism and can't find where it is

Do you know what economists mean when they talk about the nation’s “economic fundamentals”? I thought I did until I heard what Reserve Bank governor Dr Philip Lowe said they were.

When Lowe had a meeting with Treasurer Josh Frydenberg after last year’s election, I was puzzled by him saying that the economy’s fundamentals were “sound”. How could he say that when the economy had grown by an exceptionally weak 1.8 per cent over the year to March?

But at his appearance before the House of Reps economics committee last week, he had to respond to a challenging description of the state of the economy by Labor’s Dr Andrew Leigh, a former economics professor.

“We have seen declines in labour productivity for the first time on record, the slowest wage growth on record, declining household spending per capita, record household debt, record government debt, below average consumer confidence, retail suffering its worst downturn since 1990 and construction shrinking at its fastest rate since 1999,” Leigh said.

“The economy is in a pretty bad way at the moment, isn’t it?” he asked.

“That wouldn’t be my characterisation,” Lowe responded. “One thing you left out of that list is that a higher share of Australians has jobs than ever before in our history ... ultimately what matters is that people have jobs and employment and security.”

What’s more, “our fundamentals are fantastic”, Lowe went on – but this time he spelt out what he meant.

“We enjoy a standard of living in this country that very few countries in the world enjoy. More of us have jobs than ever before. We live in a fantastic, prosperous wealthy country, and I think we should remember that.”

Well, if that’s what he thinks our fundamentals mean, who could argue? Even if Leigh thought the weaknesses he was outlining were a description of our fundamentals. Maybe Lowe’s fundamentals are more fundamental fundamentals than other people’s are.

Under further questioning from Leigh, however, Lowe said he didn’t want to deny that “we have very significant issues, and the one that worries me most is weak productivity growth ... We’ve had four or five years now where productivity growth has been very weak ... in my own view it’s linked to very low levels of investment relative to gross domestic product.”

This is an important point. As former top econocrat Dr Mike Keating has been saying for some years, you can take a neo-classical, supply-side view that weak productivity improvement explains why the economy’s growth has been so weak (a view that assumes productivity improvement is “exogenous” – it drops on the economy from outside), or you can take a more Keynesian, demand-side view that weak economic growth explains why productivity improvement has been so weak (that is, productivity is “endogenous” – it’s produced inside the economy).

Keating keeps saying that it’s when businesses upgrade their equipment and processes by replacing the old models with the latest, whiz-bang models that improving innovations are diffused throughout the economy, making our industries more productive.

Why is it that our businesses (particularly those other than mining) haven’t been investing much in expanding and improving their businesses? The simple, demand-side answer is that they haven’t been seeing much growth in the demand for their products.

But Lowe sees something deeper. “I fear that our economy is becoming less dynamic [continuously changing and developing],” he told the economics committee. “We’re seeing lower rates of investment, lower rates of business formation, lower rates of people switching jobs, and in some areas lower rates of research-and-development expenditure.

“So right across those metrics it feels like we’re becoming a bit less dynamic. I worry about that for the longer term.

“Public investment is not particularly low at the moment. What is low is private investment. Firms don’t seem to be investing at the same rate that they used to, and I think this is adding to the sense I have that the economy is just less dynamic ...

“There’s something deeper going on, and it’s not just in Australia: it’s everywhere. At the meetings I go to with other central bank governors, this is the kind of thing we talk about. Something’s going on in our economies that means the same dynamism that used to be there isn’t there.”

Asked later by another MP what was causing this loss of dynamism, Low replied, “I wish I knew the answer to that ... My sense is, as an Australian and looking at what’s going on in our economy, that we’re becoming very risk-averse.” (A sentiment I know other top econocrats share.)

“It’s a global thing that happens – I think it probably happens partly when you’re a wealthy country. The standard of living here is fantastic. It’s hardly matched anywhere in the world, so we’ve got something important to protect,” he said.

“But I think in that environment you become more risk-averse. Probably with the ageing of the population, we become more risk-averse. When people have a lot of debt, they’re probably more risk-averse.

Risk-aversion seems to help explain the slow wage growth we’ve had “for six or seven years” now. “It’s the sense of uncertainty and competition that people have, and this is kind of global. Most businesses are worried about competition from globalisation and from technology, and many workers feel that same pressure.

“There are many white-collar jobs in Sydney and Melbourne and Canberra that can be done somewhere else in the world at a lower rate of pay, and many people understand that ...,"Lowe said.

“So the bargaining dynamics ... for workers is less than it used to be. And firms are less inclined to bid up wages to attract workers because they’re worried about their cost base and competition,” he said.

Doesn’t sound too wonderful to me. But not to worry. Just remember, our fundamentals are fabulous.

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Why the government's forecasts are always way off

Just to warm you up for the mid-year budget update on Monday, let me ask you: why do you think Treasury and the Reserve Bank have gone for a least the past eight years forecasting more growth in the economy than ever transpired?

Kieran Davies, a respected economist from National Australia Bank, has been checking. He says their mistake has been failing to allow for the decline in our “potential” growth rate since the global financial crisis in 2008.

Actually, Davies has checked only the Reserve’s forecasting record, not Treasury’s. But the two outfits use similar forecasting methods and use a Joint Economic Forecasting Group to ensure their forecasts are never very different.

An economy’s “potential” growth rate is the average rate at which its capacity to produce goods and services is growing each year. This is determined by the average rate at which the Three Ps are growing – population, participation (in the labour force) and productivity (output per unit of input).

Sometimes (as now) the economy’s annual demand for goods and services doesn’t grow as fast as its potential to supply those goods and services is growing. This creates an “output gap” of idle production capacity, including unemployed and under-employed workers.

When demand picks up, the economy can grow faster than its potential growth rate for a few years until the idle capacity is fully taken up and the output gap has disappeared. Once that’s happened, the potential growth rate sets the speed limit for how fast the economy can grow. If demand’s allowed to grow faster than supply, all you get is inflation.

We know from the fine print in the budget papers that Treasury’s estimate of our present potential growth rate is 2.75 per cent a year. You can be sure the Reserve’s estimate is the same. This is often referred to as the economy’s forward-looking “trend” (medium-term average) rate of growth.

Treasury’s projections of growth over the rest of the next 10 years are based on the assumption that, once the economy has returned to its trend rate of 2.75 per cent, it will then grow by 3 per cent a year for several years until the idle capacity is used up, when it will revert to 2.75 per cent. (This projection of perfection is what allows the budget papers to include an incredible graph showing the budget surplus going on forever and the government’s net public debt plunging to zero by June 2030.)

Now, here’s the trick. Because the Treasury and Reserve forecasters have no more knowledge of what the future holds than you or I do, they rely heavily on a long-established statistical regularity called “reversion to the mean”. That is, if at present the variable you’re forecasting is above its average performance, the greatest likelihood is that it will move down towards the average. If it’s below average, it’s likely to move up towards the average.

So now you know why, for at least the past eight years, Treasury has forecast that, though growth in the economy is weak at present, within a year or two it will return to trend, and then go higher. When it turns out that didn’t come to pass this time, it’s still the best bet for next year. Fail and repeat. Although the Reserve revises its forecasts every quarter, it follows the same method.

Davies’ examination of the Reserve’s forecasting record found that, since the financial crisis, it had persistently overestimated growth in real gross domestic product in the year ahead, and had nearly always overestimated growth over the next two years.

Why? Because it failed to take account of the decline in the potential growth rate since the crisis. It’s a safe bet the Reserve has stuck with 2.75 per cent. But Davies says the Reserve’s own econometric model of the economy, MARTIN, finds that potential growth has declined from 3.1 per cent in 2000 to 2.7 per cent in 2010 and 2.4 per cent in 2019.

In other words, when your forecasting method relies so heavily on reversion to the mean, if your estimate of potential growth is too high, it’s hardly surprising you’ll forecast more growth than you ever get.

But what’s wrong with the econocrats’ estimate of the potential growth? It could be in one or more of their estimates of growth in its three P components, but Davies’ checking shows it’s not population or participation, but productivity.

Davies says the MARTIN model shows that trend growth in productivity has slowed from 2 per cent a year in 2000, to 1.3 per cent in 2010 and to 1.1 per cent in 2019. This slowdown is not peculiar to Australia, but has occurred across the advanced economies.

Taking the median rate for those other economies, he estimates that the annual improvement in their productivity of labour per hour worked has slowed from 1.9 per cent in the 10 years before the crisis, to 0.8 per cent in the years since the crisis.

Davies’ equivalent estimates for us are similar: from 2.1 per cent to 1.2 per cent.

Okay, so why has productivity improvement slowed? Labour productivity has two components: “capital deepening”, where investment in more capital equipment per worker makes workers more productive, and “multi-factor productivity”, which is the improvement that can’t be explained by anything but technological progress (not more equipment so much as better equipment, plus improvements in the way factories and offices are organised) and reforms to the structure of the economy (“micro-economic reform”).

Davies finds the overall decline is mainly explained by the weakest rate of improvement in multi-factor productivity in decades – that is, little technological progress, here or overseas – but also by investment in the stock of non-mining physical capital that’s only just keeping up with the growth in the supply of labour (which, I imagine, hasn’t been helped by our need for “capital widening” to provide equipment to all the extra migrant workers).

What Davies’ digging has really exposed, of course, is the econocrats’ refusal to accept that our economy’s caught in former Bank of England governor Mervyn King’s “low-growth trap”.

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Sorry, the economy can't grow much without higher wages

I usually pooh-pooh all alleged recessions that have to be qualified with an adjective. With recessions, it’s the whole economy or nothing. But I’ll make an exception for the "household recession" – which tells you why this week’s news of continuing weakness in the economy provides no support for Scott Morrison’s refusal to stimulate it.

Households are only part of the economy, of course, but they’re the part that matters above all others. Why? Because they contain all the people. And because all the other parts – the corporate sector, the public sector and the "external" sector of exports and imports – exist solely to serve we the people.

The economy’s "national accounts", issued this week by the Australian Bureau of Statistics, showed weak growth for the fifth quarter in a row, with real gross domestic product growing by just 0.3 per cent in the September quarter of last year, 0.2 per cent in the December quarter, 0.5 per in March quarter this year, 0.6 per cent in the June quarter and now a disappointing 0.4 per cent for this September quarter.

That took the annual growth in real GDP up from a (revised) 1.6 per cent over the year to June, to 1.7 per cent over the year to September. Morrison needed a lot better than that to convince anyone bar his my-party-right-or-wrong supporters that a response to the Reserve Bank’s repeated pleas for budgetary stimulus could be delayed until the budget in May.

To see how weak that is, remember our economy’s estimated "trend" or average rate of growth over the medium term is 2.75 per cent a year – about 0.7 per cent a quarter.

But let’s get back to households and their finances. Their spending on consumption grew by an almost infinitesimal 0.1 per cent in real terms during the latest quarter, or by 0.5 per cent before taking account of inflation.

Sticking to before-inflation figures (even though all the other national-account figures I quote are always inflation-adjusted), the quarter saw households’ main source of income – wages – grow by 1.1 per cent, which other, lesser income sources shaved to growth of 0.8 per cent in total household income.

However, the amount households had to pay in income tax fell by 6.8 per cent, thanks mainly to the arrival of the government’s new middle-income tax offset. This meant that households’ disposable income grew by a much healthier 2.5 per cent.

But something led most households to save rather than spend the tax break, causing their total saving during the quarter to jump by 80 per cent and their ratio of saving to household disposable income to leap from 2.5 per cent to 4.8 per cent. That’s why their consumer spending grew by only 0.5 per cent, as we’ve seen.

It’s possible people will get around to spending more of their tax cut but, with household debt at record levels after years of rising house prices, and continuing weak wage growth, it’s not hard to believe they’re too worried to spend up at a time when the economy's hardly onward-and-upward.

They may be intending to pay down some debt, just as it’s likely many people with mortgages have allowed the fall in the interest rates they’re being charged just to speed up their repayment of the loan.

Whatever, the faster consumer spending Morrison and his loyal lieutenant assured us their tax cut would bring about hasn’t materialised. And it’s noteworthy that what little consumer spending we’ve seen has been on essentials rather than discretionary items.

One discretionary spending decision is whether to buy a new car. Separate figures show new car sales in November were down 9.8 per cent on November last year.

So if the biggest part of the economy has done next to nothing to generate what little growth we’ve seen, where’s it coming from?

Well, not from the business end of the private sector. Spending on the building of new homes was down 1.7 per cent in the September quarter and by 9.6 per cent over the year to September. Business investment spending was down 2 per cent during the quarter and by 1.7 per cent over the year.

All told, the private sector – consumer spending, home building plus business investment – fell for the second quarter in a row and is 0.3 per cent lower than a year ago.

By contrast, public sector spending – the thing Morrison & Co profess to disapprove of – is going strong, with government consumption spending up by 0.9 per cent in the quarter, and 6 per cent over the year, mainly because of the continuing rollout of the National Disability Insurance Scheme.

Public investment in infrastructure – mainly by the state governments – grew 5.4 per cent in the quarter, to be 2.1 per cent up on a year earlier. All told, growth in the public sector accounted for most of the growth in the economy overall in the September quarter.

That leaves the external sector – aka "net exports" – making a positive contribution to overall growth during the quarter, with the volume of exports up 0.7 per cent while the volume of imports was down 0.2 per cent. (Falling imports, however, are a sign of a weak domestic economy.)

Another seeming bad sign – worsening productivity, with GDP per hour worked down 0.2 per cent in the quarter and 0.2 per cent over the year – wasn’t as bad as it seems, however.

When you’ve had the good news that employment has grown faster than you’d expect given the weak growth in output of goods and services, productivity – output per unit of input – falls as a matter of arithmetic. Does that make the employment growth a bad thing?

I’ll leave the last word to Callam Pickering, of the Indeed job site: "As long as wage growth remains so low, it will be difficult for the economy to return to annual growth of 3 per cent or higher. Quite simply, it is almost impossible to have a strong economy without a healthy household sector."

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Our leaders slowly come to grips with a different economy

The beginning of economic wisdom is to understand that the advanced economies – including ours – have stopped working the way they used to and won’t be returning to the old normal.

Second in the getting of wisdom is to understand that economists are still debating why the economy is behaving so differently – so poorly - and what we can do about it.

Last week Reserve Bank governor Dr Philip Lowe gave a speech to a conference of central bankers in Wyoming revealing his acceptance that, as he put it, the economic managers are having to “navigate when the stars are shifting”.

And Treasurer Josh Frydenberg gave a speech on Australia’s productivity challenge, which offered the Morrison government’s first acknowledgement that maybe not everything in Australia’s economic garden is rosy.

The shifting “stars” to which Lowe alluded were economists' estimates of the rate of full employment and the equilibrium real interest rate – both of which have moved downwards. He said that economists have become very good at developing explanations for why this has happened.

“Even so, the reality is that our understanding is still far from complete about what constitutes full employment in our economies and how the equilibrium interest rate is going to move in the future,” he said.

He offered two likely explanations for why the stars had moved. First, major changes around the world in the appetite to save and to invest. People were saving more despite low interest rates, and were borrowing less to fund physical investment despite low interest rates.

On the saving side, these changes were linked to demographics (the ageing population), the rise of Asia (which saves a lot) and the legacy of too much borrowing in the past.

On the investment side, the links were to slower productivity improvement and “importantly, increased uncertainty and a lack of confidence about the future”.

The second major change was an increased perception of competition as a result of globalisation and advances in technology. “More competition means less pricing power, for both firms and workers,” he said.

In all this he gave the lie to the latest line that our economy is going fine, it’s just the threat from abroad that’s the problem. Nonsense. Our economy is slowing to a crawl because of weak real wage growth. The external threat just makes it worse.

After giving a learned account of our slower rate of productivity improvement (and acknowledging that it’s happening throughout the developed world), Frydenberg admitted that business investment spending was not as strong as it ought to be.

But then he stepped into the lions’ den. Rather than returning capital to shareholders, business needed to back itself – make its own luck – by using its strong balance sheet (and exceptionally low interest rates) to “invest and grow”.

The fury of the righteous descended upon him, with the business media in full cry. It really is amazing the way business people boast about the centrality of the private sector to the economy and its success, but refuse to accept any responsibility for its outcomes.

Any weaknesses in the economy are solely the government’s fault, and feel free to criticise it uphill and down dale – not to mention using problems in the economy as a pretext for rent-seeking. Don’t even think that the performance of business could be less than blameless. Who do you think invented the term “all care but not responsibility”?

Even so, I fear business is right in protesting that the reason it’s not investing is that, with demand so weak, it can’t see how expanding its production capacity could be profitable.

This problem began long before Trump started playing his crazy trade-war games, but there’s little doubt that the uncertainty he has created is adding to firms’ reluctance to commit to major investment projects. And the more people delay their investment plans until the future is clearer, the greater the risk that conditions deteriorate and the investment never gets done.

Dr Mike Keating, a former top econocrat, argues that productivity improvement is weak because business investment spending is weak. It’s when businesses install the latest and best machines and systems that new technology is diffused through the economy, lifting productivity.

So when weak wage growth leads to weak growth in consumption, you don’t get enough business investment and, hence, slower productivity improvement.

Government intervention to improve workers’ bargaining power may help speed up the flow of income through the system, but Keating believes a lasting improvement will come mainly by making education and training more effective in helping workers adapt to and adopt new technologies.

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Greater social inclusion makes us wealthier, not just happier

If you like made-up, clunky words you could call it the humanisation of economics. And it’s one of the most exciting developments in a field most people don’t consider very exciting. It’s the product of economists’ search for reasons why the economies of the developed world have stopped working as well as they used to.

This week our Reserve Bank governor, Philip Lowe, gave a short but sobering speech at a conference of central bankers in Wyoming exploring the deeper, structural reasons why economies – including ours - aren’t growing as fast as they did, and admitting this wasn’t likely to change any time soon.

A big part of the reason for weaker growth is a slower rate of improvement in the productivity of labour – the use of improved technology to increase the output of goods and services per worker.

Also this week, Treasurer Josh Frydenberg gave a long, carefully researched and highly informative speech about the deterioration in our productivity performance. His one controversial proposition has been monstered by the business media, but the speech was an encouraging sign that the Morrison government may be moving from happy slogans to careful consideration of the problems besetting our economy.

Now to my new word, humanisation. Until the past couple of decades, it was relatively easy to achieve high annual rates of productivity improvement by using bigger and better machines to increase the efficiency of our farms, mines and factories in their production of goods.

These days, goods are produced by machines, helped by humans. Services, on the other hand, are delivered by humans helped by machines. Goods have come to account for an ever-smaller share of the value of economic activity, with services contributing an ever-bigger share.

But installing more productive goods-producing machines is a lot easier than making the human providers of services (ranging from prime ministers to scientists, doctors and teachers on to waiters and cleaners) better at their jobs. This does a lot to explain the slowdown in productivity improvement.

So economists have had to turn their minds to humans, and how you make them more productive. An obvious response is to ensure they’re well educated and trained, equipped with the right skills to take them onwards in an ever-changing economy.

Equally obvious is making sure our workers are in good health – mental as well as physical. These are things we could be doing better than we are.

Less obvious is economists’ relatively recent discovery of the economic importance of “place” – where people live and work. Particularly at a time when knowledge has become a more critical ingredient, big cities have become incubators, bringing together talented workers to promote experimentation and learning, as well as enabling the transfer of knowledge. (Bit surprising in an age where digital connections are ubiquitous.)

Another less-obvious realisation is that, in the services sector, productivity depends on creativity and imagination, which drive innovation. Increasingly the services sector is the home of start-ups aimed at finding innovative ways to deliver new and existing services to larger numbers of customers.

This is very touchy-feely stuff for hard-nosed economists. One of our leading economists, Professor Ian Harper, dean of Melbourne Business School, says creativity and imagination “are generally stimulated by human interaction, social creatures that we are".

“And the more diverse we are when we gather, the more we stimulate, challenge and goad one another to greater heights of imagination and creativity.

“But for diversity to work its magic, there must also be inclusion. No matter how diverse we are, without inclusion we remain separated by physical, social, cultural and emotional barriers, and the creative spark is quenched by sameness and group think,” Harper says.

Enter the SBS network, which has commissioned Deloitte Access Economics to study the economic benefits of improving social inclusion.

By this is meant affording all people the best opportunities to enjoy life and prosper in society. It includes the Indigenous, and almost 7 million immigrants, from 270 ancestries, since 1945. All the women who should have more senior jobs. Almost 50,000 same-sex couples, and one in five people with a physical or mental disability.

About a third of small businesses in Australia, representing 1.4 million employees, are run by migrants to Australia, the great majority of whom didn’t own a business before coming here. And most migrants feel socially included.

Greater social inclusion means people are less likely to experience discrimination in employment, less likely to experience health issues, especially anxiety and depression. By lifting wages and workforce participation in districts of socioeconomic disadvantage, the benefits of economic growth can be shared more evenly across the community.

All this could save the taxpayers money, as well as making businesses more productive – which, by Deloitte’s modelling, could yield an economic dividend of more than $12 billion a year. And that’s not to mention the small matter of allowing the individuals to lead happier, more satisfying lives.

For many years economists believed economic efficiency and fairness to be in conflict. You could make the economy a fairer place only by making it a less-rich place.

That’s the economists’ exciting discovery in recent years: if you play your cards right, you can make the world fairer and a bit richer.

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Worried Lowe flouts convention to push for wage rises - now

The most important piece of local economic news this week was no news: the wage price index remained stuck at an annual growth rate of 2.3 per cent for yet another quarter. I’ve said it before but I’ll keep saying it until it’s sunk into the skull of every last politician: we won’t get back to healthy growth in the economy until we get back to healthy growth in wages.

That’s because economies are circular: all of us standing in a circle, buying and selling to everyone else. What’s the main thing people in the circle sell? Their labour. What do they do with the wages they earn? Buy stuff from the rest of the economy.

Business people (and Coalition politicians) are very conscience of the truth that wages are a cost to business. They’ve thus long had the attitude that wages should be kept as low as possible.

But equally, wages are income to wage-earners, and by far the biggest source of income for the nation’s nine million households. So the less wages grow, the less growth there is in the income households use to buy the goods and services produced by the nation’s businesses. Not good.

Get it? In the end, business has as much to lose from weak wage growth as workers do. This is the bit that many businesspeople and politicians don’t get. They’re so used to seeing the economy as my lot versus the other lot, they can’t see that, as the Salvos say, "we’re all in this together".

People – even the media – keep saying wages are flat. That’s not true. What’s true is that, according to the Australian Bureau of Statistics, the rate at which wages are rising has been flat, at 2.3 per cent a year, for the fourth quarter in a row.

In fact, wage growth has been surprisingly low since the end of 2013 – five and a half years ago.

Another point to be clear on is that it’s not low wage growth, as such, that’s the problem. If consumer prices weren’t growing, annual wage growth of 2.3 per cent wouldn’t be bad. It would be fantastic.

So it’s the rate at which wages are growing relative to the growth in consumer prices that matters. Real wages, in other words.

Standard economic theory says that, provided their real growth is no faster than the rate of improvement in the productivity of labour (that is, output per hour worked), wages can grow faster than prices without causing increased inflation.

What’s more, if wage-earners are to get their fair share of the benefit from improved productivity, real wages should be growing in line with the medium-term trend (average) rate of growth in labour productivity, which is about 1.1 per cent a year.

And because wages are the greatest single factor driving household income, household income is the greatest single factor driving consumer spending, and consumer spending accounts for about 60 per cent of gross domestic product, the economy won’t be back to a healthy rate of growth until real wages are back to growing pretty much in line with average productivity improvement.

Which, it turns out, is a bit of a worry. Why? Because it isn’t happening and doesn’t look like happening any time soon.

In the April budget, the government confidently predicted that wage growth would return to something approaching the old normal, accelerating to 2.5 per cent over the year to June this year, then 2.75 per cent by next June, and 3.25 per cent by June the year after.

We learnt this week that, as measured by the wage price index, wages fell short of the first hurdle, coming in at 2.3 per cent rather 2.5 per cent.

Worse, last week we learnt that even the Reserve Bank doesn’t share the government’s optimism.

The Reserve’s revised forecasts now see no advance on 2.3 per cent by June next year, and only the tiniest improvement to 2.4 per cent in two years’ time.

Admittedly, contrary to my contention that we won’t get to decent growth in the economy until we get decent growth in wages, the Reserve is predicting that real GDP will have strengthened to a healthy 2.7 per cent by June next year, and an even healthier 3 per cent by June 2021.

With wage growth forecast to continue weak, the Reserve is expected this improvement to happen with out much help from stronger consumer spending.

So how? Mainly through strong growth in business investment spending, exports and public sector spending on infrastructure.

Consumer spending would be helped a bit by the latest tax cuts and the cuts in interest rates. Other help would come from the falling dollar’s improvement to the price competitiveness of our export and import-competing industries, the brighter outlook for mining investment, and some stabilisation of the housing market.

Maybe. I remain sceptical. And if his behaviour last week is any guide, Reserve governor Dr Philip Lowe is pretty worried about the continuing weakness in wage growth.

It is simply not done for leading econocrats to tell employers they should be paying higher wages. But that’s just what Lowe did in his appearance before the House economics committee.

"At the aggregate [overall] level," he said, "my view is that a further pick-up in wages growth is both affordable and desirable."

Not after we’ve achieved greater productivity improvement, please note, but now. By how much does he think wages should be growing? By about 3 per cent a year, as he’s said on various occasions.

What’s more, federal and state governments – Labor as well as Coalition - should be setting the private sector a better example – or "norm" in Lowe's words – by raising the 2 to 2.5 per cent caps they’ve imposed on their own employees’ wage rises.

Thank goodness somebody’s minding the shop.

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Election hype about strong growth now back to grim reality

The grim news this week is that the weakening in the economy continued for the third quarter in row, with economic activity needing to be propped up by government spending.

The Australian Bureau of Statistics’ “national accounts” showed real gross domestic product – the nation’s production of market goods and services – grew by just 0.3 per cent in the September quarter of last year, 0.2 per cent in the December quarter and now 0.4 per cent in the March quarter of this year, cutting the annual rate of growth down to 1.8 per cent.

That compares with official estimates of our “potential” or possible growth rate of 2.75 per cent a year. It laughs at Treasurer Josh Frydenberg’s claim in the April budget – and Scott Morrison’s claim in the election campaign - to have returned the economy to “strong growth”, which will roll on for a decade without missing a beat.

It suggests Frydenberg’s boast of having achieved budget surpluses in the coming four financial years – and Labor’s boast that its surpluses would be bigger – are little more than wishful thinking, manufactured by a politicised Treasury.

The future may turn out to be golden but, even if it does, the econocrats have no way of knowing that in advance – they’re just guessing - and the road between now and then looks pretty rocky.

Why is the immediate outlook for the economy so weak and uncertain? Not primarily because of any great threat from abroad – though a flare-up in Donald Trump’s trade war with China could certainly make things worse – but primarily because of one big and well-known problem inside our economy: five years of weak growth in wages.

When you examine the national accounts, that’s what you find. Over the nine months to March, the income Australia’s households received from wages grew by 3.5 per cent, before adjusting for inflation.

That wasn’t because of strong growth in wage rates, but because more people had jobs. Weakness in other forms of household income meant that total household income grew by just 2.4 per cent.

But households’ payments of income tax grew by 4.5 per cent, thanks mainly to bracket creep. This helped cut the growth in household disposable income to 2 per cent. Even so, households’ spending on consumer goods and services grew by 2.2 per cent – meaning they had to reduce their rate of saving.

Actually, the last big fall in households’ rate of saving occurred in the September quarter. Since then, households have tightened their belts, cutting the growth in their consumer spending so as to raise their rate of saving from 2.5 per cent of their disposable income to 2.8 per cent.

Reverting to “real” (inflation-adjusted) figures, this explains why consumer spending has grown by only about 0.3 per cent a quarter since June, reducing its growth over the year to March to an anaemic 1.8 per cent.

The bureau noted that the weakness in consumer spending was greatest in discretionary spending categories, including on recreation, cafes and restaurants, and clothing and footwear – a further sign that households are feeling the pinch.

Since consumer spending accounts for almost 60 per cent of GDP, that’s all the explanation you need as to why the economy’s now so weak. But there are other factors contributing.

One is the end of the housing boom. Home-building’s contribution to growth peaked in the September quarter, with building activity falling by 2.9 per cent and 2.5 per cent in the following two quarters. It will keep falling for some time yet.

And business investment is also weak. While non-mining investment grew by 2 per cent in the quarter, mining investment fell a further 1.8 per cent. Overall, business investment was up 0.6 per cent in the quarter, but down 1.3 per cent over the year to March.

External demand is helping, however. With the volume of exports growing, while the volume of imports was “flat to down” - another sign of weak domestic demand - “net exports” (exports minus imports) are contributing to growth.

Even so, total private sector demand (spending) has actually fallen for the second quarter in a row. So, apart from the contribution from net exports, any growth is coming from public sector demand.

It grew by 0.7 per cent in the quarter to be 5.5 per cent higher over the year. This reflects the rollout of the National Disability Insurance Scheme and state spending on infrastructure. It means government spending contributed half the growth in GDP during the quarter and more than 70 per cent of total GDP growth over the year to March.

Note, it’s not a bad thing for government spending to be contributing to growth. That’s exactly what it should be doing when private demand is weak. No, the concern is not that public spending is strong, it’s that private spending is so weak.

Dividing GDP by the population shows that GDP per person fell fractionally for another quarter, and grew by a mere 0.1 per cent over the year to March.

This tells us not that the economy is on the edge of recession – how could GDP contract when a growing population is making it ever bigger? – but that, as Jo Masters of Ernst & Young has said, “growth is being driven by population growth alone, and not increased participation or productivity”.

The economy’s getting bigger, but it’s not leaving us any better off.

Speaking of productivity, the productivity of labour deteriorated by 0.5 per cent in the March quarter and by 1 per cent over the year.

Is this a terrible thing? Well, before you slit your wrists, remember that when employment is growing a lot faster than the growth in the economy would lead you to expect, a fall in GDP per worker (or, in this case, per hour worked) is just what the laws of arithmetic would lead you to expect.

Surprisingly strong growth in employment – most of it full-time – doesn’t sound like a bad thing to me. It’s just hard to see how it can last much longer.

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Beware of groupthink on why the economy’s growth is so weak

According to our top econocrats, the underlying cause of the economy’s greatest vulnerability – weak real wage growth – is obvious: weak improvement in productivity. But I fear they’ve got that the wrong way round.

We all agree that, in a well-functioning economy, the growth in wage rates exceeds the rise in prices by a percentage point or two each year. On average over a few years, this “real” growth in wages is not inflationary, but is justified by the improvement in the productivity of the workers’ labour.

If this real growth in wages doesn’t happen, then real growth in gross domestic product will be chronically weak. That’s because consumer spending accounts for about 60 per cent of GDP.

Consumer spending is driven by household disposable income which, in turn, is driven mainly by wage growth.

We would get some growth in GDP, however, because our rate of population growth is so high. But look at growth per person, and you find it’s growing by only about 1 per cent a year.

It’s long been believed that real wages and productivity are kept in line by some underlying (but unexplained) equilibrating force built into the market economy.

Since the two have kept pretty much in line over the decades, few economists have doubted the existence of this magical force, nor wondered how it worked.

In America, however, real wages haven’t kept up with productivity improvement for the past 30 years or more.

And, as Reserve Bank governor Dr Philip Lowe acknowledged while appearing before a parliamentary committee recently, for the past five years nor have they in Australia.

Unlike the unions, which see the weakness in wage growth as the result of past industrial relations “reform” shifting the balance of wage-bargaining power too far in favour of employers, Lowe remains confident the problem is temporary rather than structural.

“Workers and firms right around the world feel like there’s more competition, and they feel more uncertain about the future because of technology and competition,” he said.

So, be patient. As the economy continues to grow and unemployment falls further, workers and their bosses will become more confident, wages will start growing faster than inflation and everything will be back to normal.

To be fair, Lowe is saying we have had “reasonable” productivity improvement over the past five years, which hasn’t been passed on to wages.

It would be better if productivity was stronger, of course, and “there’s been no shortage of reports giving . . . ideas of what could be done” to strengthen it.

But last week the newish chairman of the Productivity Commission, Michael Brennan, broke his public silence to give an exclusive statement to the Australian Financial Review.

“Productivity growth has been disappointing over the last few years in Australia, as it has been in many countries. There are no magic wands . . . but there are some clear remedies for Australia that should start with a focus on governments’ capacity to influence economic dynamism and productivity,” he said.

Oh, no, not that tired old line again. If wages aren’t growing satisfactorily, that’s because productivity isn’t improving satisfactorily, and the only way to improve productivity is for governments to instigate “more micro-economic reform”.

So, weak wage growth turns out to be the workers’ own fault. Their electoral opposition to “more micro reform” is making governments too afraid to do the thing that would raise their real wages.

We’ve become so used our econocrats’ neo-classical way of thinking that we don’t see its weaknesses.

It’s saying that, if the problem is weak demand, the cause must be weak supply, and the solution must be faster productivity improvement, which can be brought about only by “more micro reform”.

This ignores the alternative, more Keynesian way of analysing the problem: if the problem is weak demand, the obvious solution is to fix demand, not improve supply.

Since the global financial crisis, the developed countries, including us, have suffered a decade of exceptionally weak growth.

We’ve had weak consumer spending because of weak wage growth, the product of globalisation and skill-biased technological change, which has diverted much income to those with a lower propensity to consume.

With weak growth in consumer spending, there’s been little incentive to increase business investment rather than return capital to shareholders.

It’s this weakness in business investment spending that’s the most obvious explanation for weak productivity improvement.

That’s because it’s when businesses replace their equipment with the latest model that advances in technology are disseminated through the economy.

Our econocrats are like the drunk searching for his keys under the lamppost because that’s where the supply-side light shines brightest.

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Weak competition may be key to economy's problems

If you think there isn’t enough competition between the big four banks, the big three power companies, the big two airlines, the big two supermarkets and in a lot of other industries, Andrew Leigh agrees with you.

He has evidence the “concentration” within our industries is increasing. What’s more, he thinks it could be part of the reason we – and the rest of the developed world - are suffering from slower economic growth and productivity improvement.

Dr Leigh is a Harvard-trained former economics professor at the Australian National University and now the federal opposition’s spokesman on competition.

In a speech this week, he said it’s hard to think of many Australian industries these days that aren’t dominated by just a few behemoths.

“Whether it’s Coles or Woolworths, Lion or Carlton, Caltex or BP, Medibank Private or BUPA, Qantas or Virgin – it seems consumers don’t have a great deal of choice where they get their goods and services from,” he says.

A standard measure of concentration judges an industry to be concentrated if the top four players control more than a third of the market.

With the ANU’s Dr Adam Triggs, Leigh calculated this measure for 481 Australian industries, finding that half of them were concentrated.

“In department stores, newspapers, banking, health insurance, supermarkets, domestic airlines, internet service providers, baby food and beer, the biggest four firms comprise more than 80 per cent of the market,” Leigh says.

(Of course, concentration isn’t a foolproof way of measuring the degree of competition. For instance, the two big newspaper companies – one of which owns this august organ – face competition from a huge number of digital news providers. And competition from more specialised retailers makes it seem department stores’ days are numbered.)

Economies of scale mean our small market is more concentrated than big economies. Leigh says our commercial banks, petrol retailers and liquor retailers are more than three times as concentrated as those in the US.

Our department stores, airlines, soft drink manufacturers and cardboard box makers are all significantly more concentrated.

As a general rule, greater market concentration gives the small number of big firms increased “market power” – ability to influence the prices they charge. It may also give them power to extract lower-than-reasonable prices from their suppliers.

Leigh notes American evidence that big companies in concentrated markets were almost 20 per cent slower in paying their suppliers than small companies were.

As to anti-competitive behaviour more generally, Rod Sims, boss of the Australian Competition and Consumer Commission, said recently that “many well-known and respected major Australian companies have admitted, or been found, to have breached our competition and consumer laws. These same companies regularly [claim] to put their customers first”.

In reaction to the growing market power of our big firms, Leigh says, governments have added civil fines for unconscionable conduct, criminalised the forming of cartels, and increased penalties for breaches of consumer protection laws.

Another problem is poor regulation of monopoly businesses that have been privatised. “Whether it is a port or an airport [or, he could have added, an electricity transmitter], it is important that governments ensure that the gains to taxpayers from selling an asset aren’t offset by the losses to consumers from higher prices,” Leigh says.

He notes that, in 2008, the ACCC received about 34,000 complaints by consumers. By 2016, it was closer to 60,000.

But why are Australian markets so heavily concentrated, and probably becoming more so? Partly because of a decline in the rate at which new businesses are being created: from an average annual rate of 16 per cent before 2010, to 13 per cent since then.

But also because of a big increase in company mergers and acquisitions. Between 1992 and 2017, their number increased almost five-fold from 394 a year to 1960 a year.

An international study has found that, in Oz, the average prices charged by large, stock exchange-listed firms were close to their marginal cost of production in 1980, and stayed there until the late ‘90s.

By the early 2000s, however, they’d risen to 40 per cent above the marginal cost. By 2010, they were 50 per cent above and by 2016 they were 60 per cent above.

In the US, there’s growing evidence that market concentration may be suppressing business investment. One study found that 80 per cent of the decline in US investment since 2000 can be explained by less competitive markets and increased ownership of shares by institutional investors.

As top US economists Paul Krugman and Larry Summers have said, the odd combination of high company profits but weak investment (at a time of low interest rates and high share prices) is just what you’d expect to see if market power was increasing.

Leigh says weak competition may help explain why wage growth is weak here and in other developed countries. “Wages are fundamentally driven by the competition between firms for workers. Less competition means lower wages,” he says.

A British study by Professor Stephen Nickell, of Oxford, found that a 25 per cent increase in market concentration leads to a 1 per cent fall in productivity.

An American study of detailed data at the firm level for all US manufacturing industries, found that mergers were associated with increased price mark-ups, but there was little evidence they boosted productivity.

Leigh concludes that “Australia has a competition problem: there is not enough of it. Our industries are concentrated. Anti-competitive conduct is rife. Our consumers are treated poorly.

Our markets show the signs of weak competition. "There has been a massive increase in mark-ups among large listed firms over the past two decades.”

What to do about it? We shouldn’t adopt an "overly permissive" approach to company mergers. We should take “a more circumspect approach to claims of [greater] efficiency when considering anti-competitive conduct”.

We should give the ACCC the investigatory powers it needs. We should ensure that penalties aren’t so small they can be treated as just a cost of doing business.

We should consider the impact of anti-competitive conduct on innovation, and recognise that unchecked market power can harm workers as well as consumers.

Sounds to me like an election manifesto.

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Not sure what the economy's up to? Nor are the experts

There are times when the rich world’s macro-economists think they’ve got everything figured, and times when they know they haven’t. The latter is where we are now, with the entire profession scratching its head and wondering what’s causing the economy to behave as it is.

The last time economists thought they had it tabbed was between the mid-1980s and the mid-2000s. The world economy was growing so smoothly they decided we’d entered the Great Moderation and began patting themselves on the back.

Always a bad sign. Next thing we knew the global financial crisis had arrived and with it the Great Recession.

But it’s now a decade since the start of that recession, and it’s clear the advanced economies aren’t back to anything like what they were – even, despite appearances, the American economy.

The problem has various symptoms, but it boils down to slow economic growth, which boils down further to much slower rates of productivity improvement than we’ve been used to. This is surprising when you consider how much digital disruption we’re seeing. Isn’t that aimed at improving productivity?

So why is it happening? That’s anybody’s guess. A host of possible explanations is being advanced and debated. It could be another decade before a new conventional wisdom emerges.

I’ve written before about the thesis that the digital revolution won’t boost productivity the way earlier waves of general-purpose technologies did, about the thesis of “secular stagnation” and yet another idea that the main trouble is decades of weak business investment.

But last week Dr Luci Ellis, a Reserve Bank assistant governor, offered her own thoughts on yet another possible piece in the jigsaw puzzle. Productivity is generated by firms, but Ellis notes that, both in Australia and abroad, the evidence suggests that levels of productivity vary widely between firms, even within the same narrowly defined industry.

“Firms that are highly productive – so-called superstar firms – tend to grow faster, grow employment faster, and pay better than firms that are a long way from the frontier of productivity”, she says.

But there’s a problem. Because these superstar firms are more productive than average, they gain market share at the expense of less-productive competitors.

The leading firms could start moving further and further ahead of the pack.

Those that lag behind would then find it harder and harder to catch up. The result could be that markets become more concentrated.

“The market leader begins to reap monopoly profits, which isn’t good for consumers and might not be good for long-run innovation and [society’s] welfare”, she says.

But must the laggard firms never catch up? That may depend on why so many firms are lagging. If it’s because they lack managerial ability, it ought to be possible for them to copy the leaders’ superior approach or even poach their rival’s managers. If so, this would lift the whole industry’s – and the nation’s – productivity.

But what if the laggards have lower productivity because they aren’t adopting the latest technology the way the superstars are? There’s evidence this is the case in other advanced economies, but Ellis says we don’t yet know if it’s true in Australia.

If this superstar pattern has arisen only recently, it could be something to do with the nature of developments in digital technology and their ease of adoption.

Previous waves of general-purpose technologies, such as electricity or the earlier round of computerisation, had the benefit of reducing the level of skill needed to operate them, whereas innovations such as machine learning and artificial intelligence seem to have a very different character, she says.

“Using machine learning and other emerging techniques to automate routine business processes seems to involve specialist skills and, often, PhD-level training in statistics or computer science. These skills are much rarer and take longer to develop than those required for the jobs that are thereby replaced.

“That doesn’t mean it’s impossible, but it could take a long time,” she says.

And get this: if leading-edge technologies are (at present, anyway) unusually costly or difficult to adopt, they become a kind of barrier to entry protecting the firms that are already using those technologies.

That would be a worry if lagging firms never caught up. And if incumbents never face rivals, they’re more likely to become complacent. “Innovation could slow down, and growth in living standards with it”, she concludes.

So, is this the big reason productivity improvement has slowed throughout the advanced economies? Far too soon to say.

But it makes an important point: the problem, and the solution, lie in the hands of our big companies.

Governments may have a role in spending more – and more wisely – on education and training, but giving up a lot of revenue to cut the rate of company tax isn’t likely to make much difference.

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It's weak investment that’s crimping productivity and prospects

US President Donald Trump said his big cut in company tax would do wonders for the economy. It’s certainly done wonders for company share buybacks. Which may be a clue to why America’s rate of improvement in productivity is so pathetic.

The continuing puzzle for the rich world’s economists is explaining the unusually weak rate of productivity improvement throughout the advanced economies. In Oz we’re not doing so badly, though we used to do a lot better.

Productivity measures the quantity of the economy’s (or just a particular business’s) output of goods and services relative to its inputs of raw materials, labour and capital equipment.

Productivity improves when a given quantity of inputs to the production process is able to produce a greater quantity of goods and services than before. It’s most commonly measured by reference to just one of the inputs, labour. So it’s output per unit of labour, usually per hour worked.

You still see people assuming that some politician or business person saying we need to increase our productivity is really saying we should work harder.

Wrong. The main way to make workers more productive is to give them more or better machines and structures to work with. That is, to invest in more physical capital.

Increasing workers’ education and training – “human capital” – also makes them more productive: better able to work with more sophisticated machines, to think of ways to make machines do better tricks, and think of more efficient ways to organise the work that’s done in a mine, farm, factory, office or shop.

Often, what the better machines and ways of organising things are intended to do is further exploit economies of scale.

Point is, it’s the almost continuous improvement in productivity, year after year, that does most to explain why we are so much more prosperous than our ancestors.

Hence economists’ consternation over the rich world’s unusually weak rate of productivity improvement for the past decade or so, and their search for explanations.

The most popular explanation among them, advanced by Professor Bob Gordon, of Northwestern University in Illinois, is one the rest of us would find hard to credit.

It’s that the present information and communication technology revolution isn’t transforming the economy to the extent that earlier general-purpose technologies – such as electricity, the internal combustion engine, the automated production line, and even running water and indoor toilets – did.

A different, but probably only partial, explanation is that much of the benefits coming from the digital revolution are going unrecognised by a system of national accounts (gross domestic product) designed to measure the industrial economy.

A month ago, I argued that another partial explanation was that the innovations of too many of our brightest and best brains were being used for nothing more productive than finding new ways to get around inconvenient laws and taxes.

Then there’s the notion of “secular stagnation” from Professor Lawrence Summers, of Harvard. Among other things, it says that the ageing of the population and very slow population growth in the rich countries (though not in Australia) means they face a future of weaker growth in consumer spending, thus diminishing the incentive for firms to invest in expansion.

Which links to the much more straightforward – and thus persuasive – explanation offered by former senior econocrat Dr Michael Keating and Professor Stephen Bell, of the University of Queensland, in their book Fair Share.

They argue that the key to productivity improvement is investment – particularly investment by businesses – and the spur to business investment is economic growth and the expectation it will continue.

Innovation is fine, but the main way some new technology is “diffused” throughout the economy is by firms replacing their old machines and structures with new ones that incorporate the latest advances.

Investment is also an essential part of the continuous process of change in the industry structure of the economy, where changes in consumers’ preferences and other developments cause some industries to contract while others expand and new industries emerge.

If firms are reluctant to invest, you don’t get enough expansion to offset the contraction.

What is businesses’ main motive for investing? Their expectations of increased demand for whatever they’re selling, Keating and Bell say.

But this is where the global financial crisis and the Great Recession come in. It was by far the deepest recession the developed world has suffered since the 1930s. The crisis was 10 years ago next month, and the recovery has been particularly weak.

Things in America may look pretty good today – unemployment is very low, profits are high and the economy grew at an annualised rate of 4.1 per cent in the June quarter.

But all is not as it seems. The latest amazing growth is the product of fiscal stimulus from Trump's income tax cuts and won’t last.

Low unemployment conceals a marked fall in the proportion of the population (particularly less-skilled middle-aged men) participating in the labour force.

Many people who lost their job during the recession have given up looking for another one. Their skills have “atrophied” – wasted away – and are a loss of human capital to the US economy.

Keating and Bell show that business investment fell more in this recession than previous ones and has been remarkably slow to recover.

Seeing no great reason to expand, US businesses have been using their profits not to reinvest but to pay big dividends and to buy back their shares on the stockmarket, hoping to boost their price. Trump’s company tax cut has pushed buybacks to record levels.

Get it? Weak economic growth in the advanced economies is discouraging businesses from investing. Weak investment means weak productivity improvement and skills atrophy. But weak productivity means more weak growth.

The authors note that business investment in physical capital, and growth in human capital, are key drivers of the economy’s “potential” growth rate in future years. Neglect them and the economy loses its ability to speed up.

The Organisation for Economic Co-operation and Development calls this a “low-growth trap”. Not an encouraging thought.

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Business is busier dividing the cake than making it grow

The developed world’s economists have been racking their brains for explanations of the rich countries’ protracted period of weak improvement in the productivity of labour. I’ve thought of one that hasn’t had much attention.

Productivity isn’t improving as fast it could be partly because of the increasing number of our brightest and best devoting their efforts to nothing more productive than helping their bosses or customers game the system.

That is, helping them find ways around our laws – tax laws, labour laws, even officially supported accounting standards for how profits should be measured and reported.

What put this into my mind was all the kerfuffle a few months ago when Labor announced its plan to abolish refunds for unused dividend franking credits.

When Paul Keating introduced dividend imputation in 1988, unused credits weren’t refundable. Only in 2001 were they made so by John Howard. At first, the cost to the budget of this minor concession was tiny. Over the years since then, however, the cost has blown out extraordinarily.

Why? Because a small army of accountants, lawyers and investment advisers started advising their clients (many of whom can’t use their franking credits because they pay no tax on their superannuation payouts) on how to rearrange their share portfolios to take advantage of the new refund.

Thus did they turn a small concession into a hugely expensive loophole. Scott Morrison’s claim that Labor had overestimated the saving to be made by closing the loophole rested on his since-refuted assumption that it had failed to take account of the way the small army would respond by further rearranging their clients’ portfolios.

But that’s just one example. The truth is that helping their customers steal a march on the government is one of the main services the entire investment advice industry uses to justify its fees and commissions.

A particular favourite is helping people with loads of super turn the cartwheels necessary to frustrate the means-test rules and still get a part pension.

Some tax agents help their clients pad out their work-related tax deductions so the punters’ tax refunds are big enough to have the agents’ fee deducted without them feeling much pain.

For years, starry-eyed economists exulted in the phenomenal growth of the banking and financial services sector on the grounds of all the financial innovation going on.

Post the global financial crisis it’s clear much of the innovation was no more productive than finding new ways to minimise tax or get around financial regulations. And, of course, all the advances in “risk management” turned out to be more about slicing, shifting and hiding risk than reducing it.

It’s an open secret that our compulsory super system leaves employees open to hugely excessive fee charging, as layer upon layer of “advisers” clip each other’s tickets and send the bill to the mug savers.

The banks’ volume of trading of currencies, securities and derivatives in financial markets exceeds by many multiples the amount required to service the needs of their real-economy customers – or even to keep markets “deep” (able to process big transactions without shifting the price much).

The banks are just betting against each other - meaning much of the bloated financial sector’s activity isn’t genuinely productive.

And now there’s the “gig economy” – Uber, Airbnb, fast-food delivery services and all the rest.

They represent a strange amalgam of genuine innovation – using the internet and smart phones to bring buyers and sellers together much more efficiently than ever before – with a lot of terribly old-fashioned tricks to get away from the tax, labour and consumer protection laws faced by their conventional competitors.

"Oh no, the people who drive cars, ride bikes or do odd jobs at our behest aren’t our employees. Gosh no. So if they don’t pay their tax, make super contributions or insure themselves, it’s nothing to do with us."

Note that even if all the cost saving extracted from the hides of these poor sods was passed on to customers, it would still be less a genuine efficiency improvement than a mere income transfer from unempowered workers to consumers, most of whom are not in need of a free kick at other people’s expense.

Now, it’s true most of the practices I’ve described are perfectly legal. And many people have convinced themselves that if it’s legal it must be moral. But they can’t have it every way: it may be legal and even moral, but what it’s not is particularly productive.

For many years business people loved to lecture the rest of us about the need to grow a bigger pie, not squabble over how the pie was divided.

Turns out a surprising amount of business activity involves ensuring their slice is bigger than yours. If so, don’t be surprised productivity improvement is slow.

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