We've handled the resources boom surprisingly well

Are we in for big trouble in the aftermath of a misspent resources boom, or has the boom been over-hyped, leaving us in good shape to face the future?

This is a matter of debate among some of Australia's most prominent economists. Professor Ross Garnaut, of the University of Melbourne, advanced the former argument last year in his book Dog Days: Australia After the Boom, and Dr John Edwards, a fellow of the Lowy Institute and member of the Reserve Bank board, makes the counter-argument in his new book, Beyond the Boom.

This week Dr David Gruen, of Treasury, weighed into the argument in a speech written with help from Rhett Wilcox. Gruen took a middle position, agreeing with each man on some points and disagreeing on others. Appropriately, he was speaking at the annual conference of economists in Hobart. They enjoy that kind of thing.

Gruen strongly disagrees with Edwards' claim that the resources boom "hasn't been as important for Australian prosperity as widely believed", saying the boom was "one of the largest changes in the structure of our economy in modern times" which "generated the largest sustained rise of Australia's terms of trade ever seen".

"The result was that resources investment increased from less than 2 per cent of gross domestic product pre-boom to around 7.5 per cent in 2012-13, an increase, in dollar terms, from around $14 billion to more than $100 billion a year," he says. "This has seen an additional 180,000 workers employed in the resources sector since the boom began and will see the capital stock in the resources sector almost quadruple by 2015-16."

But Gruen disagrees with Garnaut's implication that the economy was not well managed during the boom. He notes that all previous commodity booms - including the rural commodity boom of the early 1970s - led to blowouts in wages and inflation, followed by recessions after the boom busted.

This time, however, wages have been well controlled and the rise in prices has rarely strayed far from the Reserve Bank's 2 per cent to 3 per cent target range. The boom in the resources sector has not led to excessive growth in the economy overall. Real GDP growth averaged 3 per cent a year over the decade to 2012.

Edwards supported his claim that the resources boom has not been as important for our prosperity as commonly believed by comparing this 3 per cent growth rate unfavourably with the 3.8 per cent annual rate achieved over the decade to 2002.

But Gruen counters by noting the earlier decade "saw above-trend growth as the economy recovered from the deep early-1990s recession, with unemployment falling from above 10.5 per cent to below 6 per cent over the course of that decade".

So why has the upside of the resources boom been handled so much better than in earlier commodity booms? Gruen gives much of the credit to three micro-economic reforms: the floating of the dollar in 1983, the move to letting the Reserve Bank set monetary policy (interest rates) independent of the elected government, formalised by Peter Costello in 1996, and the decentralisation of wage-fixing, largely completed by the Keating government before 1996.

(This to me is a point worth noting: the greatest continuing benefit from the era of micro reform - but also from the move to set formal "frameworks" for conducting the two arms of macro-economic policy - is a much more flexible economy, one that is less inflation-prone and less unemployment-prone. By the way, Garnaut and Edwards can take their share of credit for these reforms.)

Next Gruen rebuts Garnaut's argument that the income the nation earned from the boom was misspent.

Garnaut might have in mind the Howard government's decision to respond to the temporary increase in collections from company tax and capital gains by cutting income tax for eight years in a row, a move that does much to explain the trouble we are having getting the budget back into surplus.

But there is more to the economy than what the feds do with their budget. And Gruen points out that, over the decade to March 2014, national consumption spending (by households and governments) actually declined from about 76 per cent of GDP to 73 per cent. If so, the nation's saving must have increased by 3 percentage points of its income (remember: income equals consumption plus saving).

Against that, over the same period bar the last few quarters, national investment has been high and rising, relative to income. "Rather than the income gains from the boom having been consumed, it would be more accurate to conclude that they were invested," Gruen says - a point Edwards also made.

(Had the nation been "living beyond its means", that would show up as a widening in the current account deficit. Instead, the deficit has been narrower in recent years.)

But what about the downside of the boom? Will the bust result in a period of contraction for the economy as a whole? Gruen's answer is "so far, so good", but he concedes that, over the next three or four years, investment spending by the miners is expected to fall from about 7 per cent of GDP to about 2 per cent or 3 per cent, a subtraction from growth of about 2 per cent to 2.5 percentage points (remembering that about half of mining investment is in imported equipment).

Remember, too, that mining production and export volumes will be growing strongly. Even so, avoiding recession will require a further significant fall in the dollar.

Gruen agrees with Garnaut that for the economy to benefit from such a "nominal" depreciation in the currency, it will need to be translated into a "real" depreciation by only moderate wage growth. But this could be achieved provided real wages grow by less than the growth in labour productivity.

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States change lanes in two-speed economy

You've heard of a Goldilocks economy where everything is just right. Well, when it comes to the states, welcome to the biblical economy, where the last shall be first and the first shall be last.

We're still looking at a two-speed economy, but the fast lane is turning into the slow lane and the slow lane into the fast.

During the 10 years of the resources boom to 2012-13, the West Australian economy grew by 62 per cent in real terms, against 48 per cent in Queensland, 30 per cent in Victoria and 23 per cent in NSW.

But, in the year to March, the mining states' "state final demand" - not as full a measure as gross state product - contracted, while NSW and Victoria steamed on.

The Victorian budget papers last month said the state was "well placed to take advantage of the national shift from mining investment towards more broad-based drivers of economic growth.

"Lower interest rates and a moderated exchange rate, compared with the highs in 2011 to 2013, are expected to benefit Victoria's industry structure."

Whereas the national economy (real gross domestic product) grew by 2.6 per cent in the 2012-13 financial year, Victoria managed only 1.6 per cent growth. And, in the financial year just ending, while the nation is expected to have managed growth of 2.75 per cent, Victoria is looking at an expected 2 per cent.

But the federal budget papers show the nation's rate of growth is expected to slow to 2.5 per cent in the coming financial year as Victoria's growth accelerates to 2.5 per cent. It's expected to reach 2.75 per cent in 2015-16.

And this week's NSW budget papers show its government expects its acceleration to be even faster. NSW managed growth of just 1.8 per cent last financial year, but it's expected to have accelerated to 3 per cent in the year just ending, and to stay at that rate in the coming year and the following one.

So, while Victoria is expecting to catch up with the national average in the coming financial year, NSW believes it has already exceeded it, and will continue growing faster than average in 2014-15. Only by the following year, 2015-16, will the nation have caught up.

Well, that's all very lovely, but how's it supposed to happen? What changes will bring it about?

You may already have noticed that whenever the economy improves, there's always a politician on hand ready to take the credit. Well, here's a tip: when they're at the national level, they're probably taking more credit than they should; when they're at the state level, they almost certainly are.

The truth is we live in a single, national economy. The six states and two territories that make up our national economy are different but highly integrated. So, to the - limited - extent that what's happening to a particular state is influenced by politicians, it's more likely to be federal politicians than state. Macro-management of the economy happens at the most macro level.

State governments don't do macro, they do micro. They manage their own financial affairs, and make decisions about planning and the regulation of particularly industries - how heavily we should tax companies developing new housing on the outskirts of the city, for instance - that do affect the growth of their state economies, but slowly and to a small extent.

So, for the most part, differences in the rates at which particular states are growing are determined by differences in the industrial structures of their economies - for instance, some have a lot of mining, some don't - and in their histories. NSW and Victoria are long established with large populations; WA and Queensland have smaller populations with more scope for development; they're frontier states.

This is why an event such as the resources boom, which has essentially come to the Australian economy from overseas, can affect states so differently.

The point, however, is that the most spectacular stage of the resources boom - the surge in construction of mining and natural gas facilities - which did most to foster the rapid growth of WA and Queensland in recent years, is going from boom to bust.

The rapid fall-off in mining construction in the coming financial year and the year after will cause those two states to grow far more slowly - maybe even contract in WA's case - while NSW and Victoria steam on.

Victoria's big advantage is that, since it has little mining, it has nothing to lose. NSW does have some mining, mainly for steaming coal, but says its big advantage is that its mining construction activity has already fallen about as much as it's going to.

It's their knowledge that we have two years of big falls in mining construction activity to come - along with the dollar's failure, so far, to fall back as much as we'd hoped - that has made the macro managers so obsessed by the need to get the "non-mining sector" growing much more strongly.

They've done this primarily by cutting interest rates to their lowest level in yonks, trying to encourage any spending that also involves borrowing, but particularly home building and home-related consumer spending.

Victoria will get some stimulus from this, but not much because it has already had a lot of building activity and may have some oversupply.

In contrast, NSW has a big backlog of home construction - arising from problems on the supply side that are the product of micro-economic mismanagement by this state government's predecessors. Its home building activity has already taken off, with much further to run.

Put all that together and you see why the last are about to start coming first.

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Job prospects not as gloomy as you may think

I can always tell when people are getting anxious about unemployment - including their own. It's when a journalist thinks they'll be increasing the sum of human knowledge by adding up the number of redundancies announced in recent weeks.

The latest list is Qantas 5000, Holden 2900 (by 2017), Toyota 2500 (by 2017), Forge Group 1470, Alcoa 980, Sensis 800, WA hospitals 250 and BHP Billiton Mitsubishi Alliance 230.

That's more than 14,000, we're told, and doesn't count the expected job loss among the makers of car parts, which "experts" put at between 25,000 and 50,000. To this you can add declining job opportunities among public servants - though no one seems to worry much about them.

There are two tricks in exercises such as this. The first is that although 14,000 or even 64,000 may seem huge numbers, they're not. Most people have no feel for just how big our economy is. Those figures have to be seen in the context of a total workforce of 11.5 million people, which grows by 170,000 in an average year, or more that 14,000 a month.

Most people have no idea how much turnover there is in the jobs market. Every month tens of thousands of people leave their jobs and a similar or bigger number take up new jobs. The economy is in a continuous state of flux.

The second trick is that the media only ever show us the tip of the iceberg. We're told about only a fraction of the things that happen. Only a fraction of them are announced to the media, so most of what happens goes unreported. And among all the things that are announced, the media select just a few of the juicier items to tell us about.

The items they select tend to be the bigger and badder ones. News that a new business has just hired 100 workers may get reported somewhere - probably in the local rag - but it won't get the trumpeting Qantas' announcement did.

So we're told about the big job losses but not the small losses and almost nothing about the job gains, big or small - even though we know from the official statistics that the gains usually outnumber the losses.

When people hear news reports about redundancies at this factory and that, many conclude we must be heading for recession. This time it ain't that simple. After a record 21 years since the severe recession of the early 1990s, we're overdue for another one and, with the economy quite weak at present, it wouldn't be impossible for us to slide into recession this year.

But the explanation for the planned job losses we're hearing so much about isn't a downturn in the economy, it's continuing change in the structure of the economy - the size of some industries relative to others.

Much of the pressure for structural change is coming from advances in technology, particularly the digital revolution. It's this that's turning the newspaper industry inside out - no one seems to shed many tears over us - and is in the early stages of cutting a swath through retailing.

In Qantas' case, it's still making the painful adjustment to the deregulation of airlines initiated by Jimmy Carter in the 1970s, combined with management incompetence and union intransigence.

But the biggest source of structural change is the resources boom and the likely permanent rise in the dollar it has brought about. People tell you it's all behind us, but when the mining industry's share of the economy doubles to 10 per cent in the space of a decade, the adjustment this imposes on the rest of the economy is profound and protracted.

Clearly, these forces for structural change are beyond the control of any federal government, Labor or Coalition. The truth so many people find so hard to accept is that there isn't a lot we can do about them except ride them out.

In its impotence, the Abbott government is claiming its plans to remove the mining and carbon taxes will be a great help. Only the one-eyed would believe that. Labor has sunk to the depths of attacking the government for its failure to protect Australian jobs and demands to see its "jobs plan". What's Labor's jobs plan? Maintain the handouts to crumbling industries.

It's seeking to exploit the fears of people who are uncertain about where it's all going to end. Well, last week Dr David Gruen, of Treasury, published projections of the various industries' shares of total employment in 16 years' time, 2030.

I must warn you these figures come with zero guarantee. Just because you're smart enough to turn the handle of an incomprehensible econometric model doesn't mean you know any more about what the future holds than the rest of us.

Surprisingly, the projections suggest manufacturing's share of total employment will decline by only a further 1 percentage point. Similar declines are projected in transport and warehousing, construction and (thankfully) financial services. The biggest relative employment decline would be in wholesale and retail trade.

Utilities, media and telecommunications, and, surprisingly, mining are projected to experience minor declines in their shares of total employment. Agriculture's share may rise by a percentage point, while that of education and health may rise by more than 1.5 points, and professional and administrative services by almost 3 percentage points.

We won't all be dead.

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Why the success of the G20 matters

It's easy to be cynical about the G20. Will the meeting of finance ministers and central bank governors in Sydney this weekend, and the leaders' summit in Brisbane in November, amount to anything more than talkfests?

People say the Brisbane summit will be the largest and most important economic meeting ever held in Australia. That's true, but it just means it will be bigger than the Sydney APEC leaders' summit in 2007 - which is remembered mainly for The Chaser boys' Bin Laden stunt.

But though it's easy to be cynical, it's a mistake. It's possible the two meetings this year will prove no more than talkshops, but that would be a great pity. And, since Australia is this year's chair of the group, it's up to Joe Hockey and Tony Abbott to make sure they're worth more than that.

The G20 began in 1999 as a group for finance ministers and central bankers, in the aftermath of the Asian financial crisis, which revealed the need for greater co-operation and co-ordination between governments in responding to crises in the global financial system and, better, making changes to the global financial "architecture" (rules and institutions) that reduced the frequency and severity of financial crises.

The formation of the G20 was a recognition that the G7 (compromising only Europe, North America and Japan) wasn't truly global, particularly because it excluded the emerging BRICS economies - Brazil, Russia, India, China and South Africa.

For a decade or two most of the growth in the global economy has come from the BRICS, and the developing economies now account for more than half gross world product. For a better global spread, the G20 also adds Argentina, Indonesia, Mexico, Saudi Arabia, South Korea, Turkey, the European Union and, of course, Oz. With just these 20, it accounts for 85 per cent of gross world product.

In 2009, in the aftermath of the global financial crisis, the G20 was upgraded from just finance ministers to include summits of presidents and prime ministers, an acknowledgment of the way economic power had spread beyond the North Atlantic. But why do we need these get-togethers?

Because, as Christine Lagarde, boss of the International Monetary Fund, said recently: "The breakneck pattern of integration and interconnectedness defines our times."

It has become unfashionable for the media to talk about globalisation, but it's continuing apace. As Mike Callaghan of the Lowy Institute said last week: "If there is one lesson from the [global financial] crisis, it is the interconnectedness between financial markets. Events in US financial markets had worldwide consequences. We need co-operation to deal with globally operating financial institutions."

These days, global integration is being driven less by deregulation and more by advances in technology, particularly the information and communications revolution. One part of this is the way the internet has globalised the media.

News of an economic calamity in one country is now conveyed to the rest of the world almost instantly. Financial traders in New York or other centres can start moving money out of the affected country in no time. They can then take a set against neighbouring countries they merely fear may have a similar problem, giving rise to a big problem called "contagion", where trouble spreads like a communicable disease.

And TV news that a few banks are tottering in Europe can scare the pants off consumers and business people in countries around the world, prompting them to stop spending until their confidence returns.

But it's not just crises. As Callaghan reminds us, more and more businesses now operate globally. Goods are more likely to be "made in the world", with inputs from many countries rather than just one. So the trade policies agreed by the international community have to adapt to the new reality that such "value chains" are increasingly driving world trade.

Then there's tax. The more businesses that operate globally, the more businesses that are able to exploit loopholes between different countries' tax laws, shifting their profits to countries with low tax rates. This is eroding the tax base of many countries - including ours - so their taxes aren't raising as much revenue as they should be.

In other words, technology-driven globalisation - the ever-reducing barriers separating particular economies - is throwing up problems that can't be solved by individual countries acting individually.

So we need greater communication, co-operation and co-ordination between countries, first, to discourage countries from pursuing "beggar-thy-neighbour" policies - I attempt to fix my problems at your expense, which usually provokes retaliation, so we all suffer - and, second, to find group solutions to the various problems.

The first couple of G20 leaders' summits in 2009 were quite effective in ensuring the Great Recession wasn't as bad as it could have been. But the truth is the G20 has been running out of momentum, resorting to high-sounding rhetoric while getting bogged down in excessive detail.

Considering how crisis-prone the global economy has become, it's important merely for world leaders, treasurers and central bankers to know each other, have face-to-face meetings and phone each other.

But we also need more joint action, and if the G20 doesn't lift its game the big boys will stop coming to meetings and eventually shift their interest to a smaller, more cohesive group which includes China and a few others, but excludes Australia.

Clearly, it wouldn't be in our interests to lose our seat at the top table. That's why it's so important we use our position as this year's chair to get the G20 back on the rails. Many pre-meeting phone calls need to be made by Hockey and Abbott to their counterparts, to gather support on the directions to be taken.

Then they need to chair the meetings effectively, discouraging set-piece speeches and encouraging interchange that improves mutual understanding and makes progress on a limited range of key issues.

We have a lot to gain or lose.

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Why the end of car-making isn't such a terrible thing

One advantage of getting old is meant to be a greater sense of perspective. You've seen a lot of change over your lifetime and seeing a bit more doesn't convince you the world is coming to an end. Unfortunately, getting old can also leave you convinced every change is for the worst as the world goes to the dogs.

A lot of people have been disturbed by the news that Toyota's closure as a car maker in 2017 will bring an end to the manufacture of cars in Australia, with the loss of many jobs also in the parts industry.

But my guess is the most disturbed observers will be the old, not the young. I doubt if many young people had been hoping for a career in the car industry. And I know that few people - young or old - buy Australian-made cars.

That's not a cause for guilt, but for being sensible. To regret the passing of an industry whose products few of us wanted is just sentimentality, making no economic sense.

A lot of the dire predictions we're hearing won't come to pass. However many jobs the vested interests are claiming will be lost, they're almost certainly exaggerating.

That's particularly true of the alleged flow-on effects, which are often calculated on the assumption that any money which would have been spent buying the product in question will now not be spent on anything.

I've never believed car making was of special strategic significance to advanced technology. Every industry claims to be special. And I've heard the claim that this spells "the end of manufacturing in Australia" too many times in the past to believe it.

You think 35,000 is a huge number of jobs to be lost? It isn't. It's 0.3 per cent of all jobs, equivalent to about two months' net job creation in a normal year. You think this could put the economy into recession? We're overdue for another recession but this isn't nearly big enough to be the main cause of one. Even if it was, it wouldn't happen until 2017.

It's true some of the workers who lose their jobs won't be able to find alternative jobs, and some that do won't find jobs as well paid. But far more will find jobs than many of us imagine. Naturally, it's important for governments to give affected workers a lot of help to retrain and relocate.

Some people assume an imported car creates no jobs. Far from it. Are you able to buy an imported car for anything like the price at which it crosses our docks? Of course not. Most of the gap between the landed price and the retail price goes on creating jobs for Australian workers in our extensive car-distribution industry.

The fact is the sale, fuelling, servicing and repair of cars has always involved far more jobs than the making of cars and car parts has.

I've been responding to people's fears about the decline in manufacturing for almost as long as I've been a journalist because manufacturing's share of total employment began declining well before I joined Fairfax in 1974.

The truth is the industrial structure of our economy has been changing slowly but continuously since the First Fleet. A lot of angst has been generated over that time but the fact remains we're infinitely more prosperous today than we were then - with a much higher proportion of the population in the paid workforce.

The changing mix of industries is actually a primary cause of our greater affluence. Countries that try to prevent their industry structure changing are the ones that stop getting richer.

To put the latest developments into context, let me show you the bigger picture of Australia's economic history, drawing on a Reserve Bank article. Throughout much of the 19th century, agriculture accounted for about a third of the nation's total production, with mining bigger than manufacturing.

By Federation, agriculture provided about 25 per cent of total employment, with manufacturing providing 15 per cent and mining about 8 per cent. By the 1950s, however, manufacturing had grown to 25 per cent, agriculture was falling towards 10 per cent and mining was down to 1 per cent.

So as the shares of agriculture and mining declined, manufacturing's rose. But from the 1960s, manufacturing's share of total employment started falling from its peak of about 25 per cent to be down to about 8 per cent today.

Remember, however, that an industry's declining share of the total doesn't necessarily mean it's getting smaller in absolute size. Although today agriculture accounts for only about 3 per cent of the total, the quantity of rural goods we produce has never been higher. And manufacturing's output began falling only in recent years.

So an industry's share falls mainly because other industries are growing faster. And, with the exception of mining, the sector that has provided virtually all the growth is services. It accounted for half our jobs even in the 19th century, but from the 1950s its share took off, rising sharply to about 85 per cent today. Most of the growth has been in health, education and a multitude of "business services".

Many older people find the relative decline of manufacturing disturbing but I can't see why. Services sector jobs tend to be cleaner, safer, more skilled, more value-adding, more satisfying and better paid.

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Top 10 economic reforms that transformed Australia

1. Floating the dollar
Letting the market set the value of the Aussie dollar after December 1983 allowed it to fluctuate between US48c and $US1.10 so far, making it an absorber of shocks from the rest of the world. This has made the economy more stable and stopped the resources boom causing an inflation blowout.

2. Deregulating the banks
Introducing foreign banks and allowing banks to set their own interest rates made it much easier to get a loan and increased competition between banks and other lenders, but led to excessive lending to businesses and caused the deep recession of the early 1990s.

3. New taxes on capital gains and fringe benefits
In October 1985 Paul Keating announced new taxes but cut the top income-tax rate from 60 per cent to 49 per cent. He also abolished negative gearing, but reversed this under pressure from estate agents.

4. Removing import protection
In May 1988 Keating announced the virtual phasing out of the import duties and quotas imposed on most manufactured goods. Predicted demise of manufacturing industry did not materialise.

5. Privatising government businesses
Sale of the Commonwealth Bank began in 1991 and Qantas in 1992. The Howard government sold Telstra in three tranches from 1997. State governments sold their banks, insurance companies and some power producers and distributors.

6. Enterprise bargaining
In 1993 the Keating government ended centralised wage-fixing through a "national wage case" and introduced collective bargaining at the enterprise level. In 2005, Work Choices sought to promote individual contracts by reducing worker protections, further encumber unions and end reliance on industrial rewards. The Rudd government reversed the most extreme parts of Work Choices, but left much of it in force.

7. National competition policy
In 1995 Keating sought to encourage deregulation and privatisation by state governments and tighten the Trade Practices Act's restrictions on anti-competitive behaviour. Premiers tended to drag their feet.

8. Central Bank independence
In 1996 Peter Costello allowed the Reserve Bank to make its decisions independent of the elected government, endorsing its target of holding inflation between 2 per cent and 3 per cent, on average. The Reserve has raised interest rates more than a politician would - including during the 2007 election campaign - but this has kept inflation under tighter control than when politicians were in charge.

9. Goods and services tax
The start of the GST in 2000 came 25 years after it had been proposed by a major inquiry. It replaced wholesale sales tax and various unconstitutional or inefficient state taxes. Much death and destruction were predicted; little eventuated. But now GST is showing signs of wear and needs renovation.

10. Taxes on mining and carbon
Wayne Swan planned to raise huge sums from taxing miners' high profits and use the proceeds to give tax cuts and concessions to business and individual savers. He also used a tax to impose a price on carbon dioxide emissions. Both reforms were badly mishandled and Tony Abbott has pledged to reverse these reforms.

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Garnaut cries from the economic wilderness

Professor Ross Garnaut, now at the University of Melbourne, is our most prophetic economist. In a much-discussed speech last week he prophesied that the easing of the resources boom would bring "hard times after more than two decades of extraordinary prosperity".

He says we face three big challenges if we're to avoid the end of the long boom leaving us with much to regret. The first is that our real exchange rate now needs to fall a long way to be consistent with full employment.

The second big challenge, he says, is to change entrenched expectations that living standards will rise inexorably over time; that household and business incomes and public services will rise and taxes will fall, as they have done for a generation.

"Those expectations must be reversed in the process of dealing with the legacy of the boom, or our efforts in reform will be defeated by bitter disappointment with political leadership and eventually political institutions," he says.

I think he's making two points. One is that economic life consists of downs as well as ups, losses as well as gains, and anyone who imagines governments should or even could shield them from all unpleasantness is destined for disillusionment. The need for income earners not to be compensated for the higher cost of imports caused by a fall in the dollar is a case in point.

The other point is we must disabuse ourselves of the notion economic life is about sitting around waiting for another serve of prosperity to be handed to us on a plate. Outside of resources booms, we have to make our own luck.

The third big challenge we face is that our political culture has changed since the reform era of 1983 to 2000, in ways that make it much more difficult to pursue policy reform in the broad public interest. "If we are to succeed, the political culture has to change again," he says.

Policy change in the public interest seems to have become more difficult over time as interest groups have become increasingly active and sophisticated in bringing financial weight to account in influencing policy decisions, he says.

"Interest groups have come to feel less inhibition about investment in politics in pursuit of private interests.

"For a long time ... it has been rare for private interests of any kind to be asked to accept private losses in the interests of improved national economic performance. When asked, the response has been ferocious partisan reaction rather than contributions to reasoned discussion of the public interest in change and in the status quo.

"A new ethos has developed in which there can be no losers from reform. Business has asserted a property right to continuing benefits of regulatory mistakes. It demands compensation for corrections to errors in policy.

"Households have been led to expect that no policy changes will cause any of them to be worse off."

Garnaut says that whether comprehensive public interest reform is possible depends a great deal on the quality of political leadership. Quality of leadership is partly about capacity to explain to citizens the nature of the choices that must be made on their behalf. He's no doubt right about the need for better leadership, but when the rest of us dwell on that lack it becomes a cop-out. It's actually a symptom of the very easy-prosperity syndrome Garnaut is warning about.

The Business Council in particular is prone to sitting around praying for God to send us leaders "prepared to lose their jobs to get things done". That's a quality as rare among politicians as it is among chief executives. If we wait for a policy suicide bomber we'll be waiting a while.

In truth, politicians are more followers than leaders. They deliver those changes being urged on them by what I'd call the nation's opinion leaders and Garnaut calls "a substantial independent centre of the national polity".

Pollies make risky reforms when they know these people have already done much educating of community power-holders on the necessity for the reforms in the public interest, and when they're confident the urgers will stand by them when the flak is flying. (The Business Council always finks out at that point.)

And Garnaut offers a further warning to those who, like the Business Council, dream of "reforms" that advance their private interests at the expense of the rest of us. Reform must be clearly in the public interest if certain groups are to be persuaded to cop losses for the greater good.

Finally, "it is a lesson of Australian history that successful periods of restraint require the equitable sharing of sacrifice". Developing a framework of equity will be important to the success of a choice by the nation to put the public interest ahead of business as usual.

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The economic geography of big cities

If you've seen those ads the mining industry is running you probably realise the entire economy is riding on the miners' backs, and if asked to pay another dollar more in tax they'll up sticks and shift their mines to some better-run country like Peru or Nigeria.

If you've spoken to a farmer any time in the past 50 years you'll know it's actually farming that's propping the economy.

In either case you'll be surprised to know the truth: according to estimates by the Department of Infrastructure and Transport, 80 per cent of Australia's economic activity takes place in Australia's major cities.

That's because the great majority of us live in big cities. We live there because that's where most of the jobs are. Equally, most of the jobs are where the people live because most jobs involve doing things for people (such as bringing them the news).

But it's not by accident that so many of us happen to be piled into a handful of cities (as are people in all developed countries and, increasingly, many developing countries). We pile together because it's more efficient economically, thus making us more prosperous.

For one thing, it saves on transport and other distribution costs. For another, outfits such as hospitals and schools - even shopping centres - gain economies of scale when they have more people to serve.

But that's just the start of the "economies of agglomeration", as Jane-Frances Kelly and Peter Mares point out in their report for the Grattan Institute, Productive Cities.

We're used to dividing up the economy by sector - agriculture, mining, manufacturing and the big one, services - and focusing on how these sectors' shares of the economy are changing. But this blinds us to an important development.

"One of the most significant long-term shifts in advanced economies is towards knowledge-intensive activities. These take place across all sectors of the economy," the authors say. In other words, there are knowledge-intensive jobs in each of the sectors - but almost all of them are located in the cities.

Knowledge-intensive activities tend to involve customised problem solving, which requires significant intellectual effort. So such workers solve problems and generate ideas. Their jobs are clean, safe, well-paid and intellectually satisfying. They're the way for Australia to go if we want a better future than just farming and mining (lucrative though they are).

But here's the point: knowledge-intensive activities grow best in big cities. This is because people and businesses learn from each other, and the closer together they are the more they learn. According to the urban economist Edward Glaeser, the "central paradox of the modern metropolis" is that even as the cost of connecting across distance falls, so the value of being close to other businesses rises.

As well, the more businesses and workers cluster together, the more they each benefit from "deep" labour markets. Firms have more workers to pick from; workers have more firms to pick from. Jobs can become more specialised, and ever-increasing specialisation is one of the main ways economies have become richer over the past 200 years.

When you specialise in something you get better at it. And the individual worker more closely fits the needs of the individual employer (which makes the worker more valuable and able to command a higher salary). But the more specialised you are the more contact you need with others in your specialty to help you keep up.

The report says that, adapting to changing economic circumstances, Australia's largest cities have evolved from compact colonial cities where jobs and houses were close together and most people walked to work, to cities that spread outwards into suburbs.

"This transition was made easier by changing transport technologies: first trams and trains, then buses and cars. The transition further separated the worlds of work and home, an arrangement that was well suited to a 20th-century economy driven largely by manufacturing, when industry could often be a dirty and noisy neighbour."

Initially this led to the "hollowing out" of inner cities as both residents and jobs moved to the suburbs. In the decades since 1980, however, the trend began to turn around, as services began to replace manufacturing as the main source of new jobs.

Combined with factors such as traffic congestion and rising fuel prices, this helped to prompt a resurgence of CBDs and inner suburbs as places to live and work.

The point here is that the economic efficiency of cities - their ability to generate well-paying jobs - turns on where the jobs are, where the homes are and the adequacy of the transport system that allows us to move between the two.

But the report finds that labour markets are shallow in significant parts of Australia's biggest cities. "In many suburbs - particularly outer suburbs - residents can reach fewer than 10 per cent of all metropolitan jobs with a reasonable commuting time," it says.

The answer is not for governments to try (and often fail) to create jobs in outer suburban areas. People want to live closer in, and many of them want units rather than houses. So the answer is to remove the disincentives faced by developers building in established suburbs and stop established suburbs from being "locked down" by restrictive zoning and planning rules.

The way to reduce traffic congestion and increase the capacity of city transport systems is to start charging for the use of roads and use the revenue to expand public transport.

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How what's hurting most is also what saved us

While many business people see the economy as badly performing and badly managed, our econocrats see it as having performed quite well and better than could have been expected. Why such radically different perspectives on the same economy?

Partly because business people - particularly those from small businesses - view the economy from their own circumstances out: If I'm doing it tough, the economy must be stuffed. By contrast, macro-economists are trained to ignore anecdotes and view the economy from a helicopter, so to speak, using economy-wide statistical indicators.

A bigger difference, however, is that business people are comparing what we've got with what we had, whereas the economic managers are comparing what we've got with what we might have got, which was a lot worse.

Business people know everything was going swimmingly in the years leading up to the global financial crisis of 2008-09, but in the years since many industries - manufacturing, tourism, overseas education, retailing, wholesaling - have been travelling through very rough waters.

The econocrats, however, have a quite different perspective: whereas the rest of us love a good boom, those responsible for managing the economy view them with trepidation. Why? Because they know they almost always end in tears and recriminations.

Particularly commodity booms. As a major exporter of rural and mineral commodities, we've had plenty of these in the past. They've invariably led to worsening inflation, a blowout in the trade deficit and ever-rising interest rates, followed by a recession and climbing unemployment. The latest resources boom was the biggest yet, involving the best terms of trade in 200 years, leading to a once-a-century mining investment boom. It could have - even should have - led to a disaster, but it didn't.

The macro managers' primary responsibility is to maintain "internal balance" - low inflation and low unemployment - which involves achieving a reasonably stable rate of economic growth. No wonder commodity booms make them nervous.

So how have they gone? As Dr Philip Lowe, deputy governor of the Reserve Bank, said in a speech this week, over the three years to March, economic output (real gross domestic product) has increased by 9 per cent, the number of people with jobs has risen by more than half a million and the unemployment rate today is 5.4 per cent, the same as it was three years ago.

Underlying inflation has averaged 2.5 per cent over the period, the midpoint of the medium-term inflation target. "So over these three years we have seen growth close to trend, a stable and relatively low unemployment rate and inflation at target," he says.

And that's not all. The investment boom hasn't led to a large increase in the current account deficit. There hasn't been an explosion in credit. Increases in asset prices have generally been contained. And the average level of interest rates has been below the long-term average, despite the huge additional demand generated by the record levels of investment and high commodity prices.

So "we have managed to maintain a fair degree of internal balance during a period in which there has been considerable structural change, a very large shift in world relative prices, a major boom in investment and a financial crisis in many of the North Atlantic economies", Lowe says.

So how was this surprisingly OK performance achieved? Well, that's the funny thing. The two factors that have done so much to make life a misery for so many businesses - the high dollar and increased household saving - are the very same factors that have been critical to our good macro-economic performance.

The high dollar brought about by the resources boom has reduced the ability of our export industries to compete in the international market and reduced the competitiveness of our import-competing industries in our domestic market, making life very tough for many of them.

For a while, many hoped the dollar's rise would be temporary, but now "there is a greater recognition that the high exchange rate is likely to be quite persistent and firms, including in the manufacturing sector, are adjusting to this", Lowe says.

"Many are looking to improve their internal processes and address inefficiencies. They are focusing on products where value-added is highest and where the quality of the workforce is a strategic advantage. We hear from businesses right across the country that they are looking for improvements and that many are finding them."

But here's the other side of the story. Had we not experienced the sizeable appreciation, he says, it's highly likely the economy would have overheated and we would have had substantially higher inflation and substantially higher interest rates.

"This would not have been in the interests of the community at large or ... in the interests of the sector currently being adversely affected by the high exchange rate." And it's unlikely we would have avoided a substantial real exchange-rate appreciation, with it coming through the more costly route of higher inflation. (The real exchange rate is the nominal exchange rate adjusted for our inflation rate relative to those of our trading partners.)

Next, the rise in the net household saving rate from about zero to 10 per cent of household disposable income since the mid-noughties represents about an extra $90 billion a year being saved rather than consumed by households.

This reversal of the long-running trend for consumption to grow faster than household income explains much of the pain retailers and wholesalers have been suffering. We've had more retail selling capacity than we've needed, forcing shops to fight for their share of business.

But had households spent that extra $90 billion a year on consumption, it's likely there would have been significant overheating. The exchange rate would have been pushed up, the trade balance would be worse and there would have been more borrowing from the rest of the world.

"And both inflation and interest rates would have been higher. I suggest that these are not developments that would have been warmly welcomed by most in the community," Lowe concludes.

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For true productivity gains, co-operate don't fight

When Peter Reith replaced Labor's Industrial Relations Act with the Workplace Relations Act in 1996, he changed the act's principal objective from the "prevention and settlement of industrial disputes" to "providing a framework for co-operative workplace relations". I'm not sure the Howard government always lived up to that ideal, but it was certainly the right idea.

John Howard was fond of saying we should emphasise the things that unite us, not the things that divide us. Again, I'm not sure he always lived up to that, but it was the right idea - particularly for relations between bosses and workers.

The principal objective of the Fair Work Act is to provide a "balanced framework for co-operative and productive workplace relations that promotes national economic prosperity and social inclusion". That's even better.

At a time when so many of our industries are under so much pressure to change from so many sources - the high dollar, the prudent consumer, the digital revolution, the deregulation of world airlines - we need all the co-operation we can get between employers and unions.

Most economists have rejected the claims of some that our seemingly poor productivity performance over the past decade can be blamed on the Fair Work Act that came into full effect only at the start of 2010.

But that's not the same as saying the act is without fault. And it's certainly not to deny the need for our industrial relations to be as conducive as possible to improved productivity.

If we were to believe all we see and hear, we'd conclude relations were pretty bad at present. I'm not convinced that's true. More likely, a handful of highly publicised, bitter disputes has provoked a lot of tough talking on both sides of the fence, and left us with the impression things are worse than they really are. Even so, too much of the debate about Fair Work has focused on whether it's got the balance right between the adversaries, and not enough on how much it's helping to turn adversaries into partners.

There are plenty of people who've always hated the unions, and plenty who've always hated the bosses. All of us can be lured into playing that game but, in all our interests, we need to resist the temptation. It's self-indulgent at a time when we need to pull together.

For industrial relations to become more co-operative, and hence more productive, we need give and take on both sides.

What managers need to accept is that workers are entitled to reasonable treatment. Managers want to do well out of their association with a business; so do workers. And, to adapt a quote, the economy was made for man, not man for the economy.

There are plenty of ways to improve the productivity of labour - and certainly, to cut the cost of labour - that involve making life more uncertain, insecure, unpleasant and even unhealthy for workers. If that's what "flexibility" means, it's hardly surprising workers resist it. Good managers resist the temptation to go down that shortcut to supposed prosperity.

Many proposals to "outsource" production or resort to contract labour aren't about two-way flexibility but about cutting costs by escaping existing in-house arrangements over pay and conditions. Good managers need to do better than that.

Australia's workers are relatively highly paid, with good conditions. This is a good thing, not a bad thing. It's certainly nothing to try to make workers feel guilty about. As any economist will tell you, our high pay rates are justified by our relatively highly educated and skilled workforce, by the high-quality capital equipment it works with, and by the sharing of this nation's considerable wealth.

The goal of management should not be finding ways to escape these high costs, but finding ways to defend our high wage rates with high productivity. In this endeavour they're entitled to full co-operation from their workers.

What workers need to accept is that the world economy is changing rapidly and as it changes we must change. Businesses must respond to the changing commercial pressures on them, or they will fail.

In a capitalist economy, businesses need to earn an adequate return on the shareholders' funds invested in them. In the final analysis, managers are paid to ensure their business remains profitable. They will do whatever it takes.

Such profits are not illegitimate, and they're not available to be plundered by workers demanding excessive wage rises or refusing to change in response to the changing pressures on the business.

Workers and their unions simply cannot pretend the pressures for change bearing down on the business are a problem for management, but not for them. The more they resist a creative response, the more managers will go around them in the search for cheaper labour.

Change - painful change - can't be avoided by attempting to strongarm management into including guarantees of job security in enterprise agreements. Guess what? There are no guarantees in an ever-changing market economy.

Much of the change being imposed on various industries will inevitably involve redundancies. The most workers can expect is decent redundancy pay, the avoidance of excesses designed to impress the sharemarket, and a preference for redundancies to be voluntary.

Professor Paul Gollan, of Macquarie University, argues the key to greater co-operation in the workplace is giving workers greater "voice" - formal arrangements within businesses by which employees are consulted, given their say and encouraged to propose improvements and "add value". Studies confirm such processes are associated with greater productivity.

Senior managers' "prerogative" - about which I say more in my little video on the website - is to ensure their staff is fully informed about the challenges facing the business.

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Fair Work debate fans the fighting mood

THE most disappointing thing about the review of the Fair Work Act and the reaction to it is the way they push industrial relations towards being more adversarial rather than less.

At time when so many businesses face unusually challenging pressures for structural change, we need more co-operation between the industrial partners, not more class struggle and barracking from the sidelines.

The standard approach to industrial relations reform is to see it as about "getting the balance right". There's a fundamental conflict of interest between labour and capital, we think, plus a wide difference in bargaining power, so the objective is to ensure the eternally battling parties are fairly evenly matched.

That's the public policy objective, of course. If you're on one side or the other, your objective is simply to get the rules changed in a way that gives you the drop over the other side.

The conventional view is that, with its attempt to install individual contracts as the chief form of bargaining and marginalise the unions, WorkChoices pushed the balance too far in the direction of employers.

So it was fair enough - particularly after voters seemed to reject WorkChoices so decisively - for Fair Work to push the balance back the other way. The review's job was to decide whether the balance had now been pushed too far the other way.

The trouble with the review is that it didn't do much more than adjudicate the rival claims, legal section by section. With two of the three members of the review being lawyers - and one a judge - you couldn't have expected anything else.

Although the media portrayed the employer groups' reaction to the review as angry, I suspect they were quite pleased. They won more points than they expected to, while the unions won fewer.

One trouble with the traditional approach to regulating industrial relations - supervise a fair fight - is that it's reinforced by all our other adversarial institutions. It comes naturally to lawyers, but also to politicians.

There's nothing Julia Gillard and Labor would love more than a rematch on industrial relations and there are plenty of urgers on the Liberal sidelines spoiling for a punch-up.

For once, however, Bruiser Abbott isn't tempted, judging correctly that such a them-and-us contest would greatly favour "them". Electorally, WorkChoices is still toxic.

Should Abbott win the election, it will be interesting to see what gap emerges between his pre-election rhetoric and his post-election policies. Many of his backers are hoping for a yawning chasm.

Just as the traditional industrial relations approach is adversarial, so the IR experts are highly factionalised. Most academic experts long ago chose sides between the unions and the employers. Trying to find experts who can see both sides of the argument is one of the trials of my job.

Wherever there are adversaries, there you can expect to find the media, doing their best to increase the fun by amplifying the conflict. What's new is to have the national dailies taking sides in their reporting, with the union side of the story virtually unmentioned.

Whenever there's a brawl, it's hard for interested bystanders to resist the temptation to join in. I suspect that's the story with big business leaders: they're not greatly affected, but they know whose side they're on.

Consider the results of last week's CEO Pulse survey of 96 chief executives. Fully 82 per cent of them think Fair Work is having a negative impact on productivity. That's for the whole economy. For their own industry, it's down to 60 per cent. And for their own business? Down to 51 per cent, with 45 per cent saying it's having no effect.

Coming from people with such obvious alignment, that tells me we don't have a lot to worry about. It reveals the classic survey gap between first-hand experience and the general impression people have picked up, mainly from the media.

My guess is a few big, militant unions are taking every advantage of Fair Work to make unreasonable demands. And they're being vigorously opposed by a few equally militant, unreasonable big businesses.

But we shouldn't allow people with a vested interest in conflict to misdirect us. The real problem with Fair Work is that it's not doing as much good as it could be at a time when bosses and workers need to pull together.

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Productivity story not what we've been told

At last instead of jumping to conclusions and riding hobby horses we're making good progress in analysing the causes and cures of the slowdown in our economy's productivity improvement. There's more to it than you may think.

Following the analysis by Saul Eslake for the Grattan Institute we've had a contribution from the Productivity Commission's great productivity expert, Dean Parham, and a synthesis of the state of our knowledge by Patrick D'Arcy and Linus Gustafsson in the latest Reserve Bank Bulletin. Let me tell you what they find.

Productivity refers to the efficiency with which an economy employs resources (inputs) to produce economic output (goods and services). It matters because improvement in productivity is the key driver of growth in income per person - and hence, our material standard of living - in the long run.

The trend in productivity improvement is determined by the development of new technologies and by how efficiently resources - the "factors" of production: land, labour and capital - are organised in the production process.

The commonest and easiest way to measure productivity is to measure the productivity of labour. You take the total quantity of goods and services produced in a period and divide it by the total number hours of labour used to produce it, thus giving output per unit of labour input.

Figures for the market economy show labour productivity improved at the annual rate of 1.8 per cent over the 20 years to 1994, then by 3.1 per cent over the 10 years to 2004, then by 1.4 per cent over the seven years to 2011.

You see there how productivity surged during the second half of the 1990s, but has since slowed to a rate of improvement ever lower than during the lacklustre '70s and '80s. That's what the fuss is about.

The main way we improve the productivity of workers is to give them more machines to work with. Economists call this "capital deepening". Another way to think of it is that we've increased the ratio of (physical) capital to labour.

The part of the improvement in labour productivity that can't be explained by capital deepening is referred to as "multi-factor productivity" - the quantity of output produced from a given quantity of both labour and capital.

It turns out that capital deepening accounts for 1.3 percentage points of the annual improvement in labour productivity during both the 20 years to 1994 and the 10 years to 2004, and then an amazing 1.8 percentage points over the seven years to 2011.

The first conclusion from this is that the slowdown in labour productivity can't be explained by any decline in business investment in more machines. It's thus fully explained by a deterioration in multi-factor productivity.

Multi-factor productivity improved at an annual rate of 0.6 per cent over the 20 years to 1994, by 1.8 per cent over the 10 years to 2004 and by - get this - minus 0.4 per cent over the seven years to 2011.

Fortunately, the position isn't as bad as that looks. The decline in multi-factor productivity is more than fully explained by the special circumstances of just two industries: mining and "utilities" (electricity, gas and water).

Mining has seen huge investment in new production capacity that has yet to come on line. And the sky-high prices for coal and iron ore have justified the exploitation of more inaccessible deposits. Utilities have seen much investment in electricity and water infrastructure to improve the reliability of supply.

When you exclude mining and utilities you find, first, that over the past seven years capital deepening has proceeded at the same 1.3 per cent annual rate as experienced in the previous 30 years. Second, although the annual rate of multi-factor productivity improvement has slowed from 1.9 per cent over the 10 years to 2004 to plus 0.4 per cent over the latest period, that's only a bit slower than the 0.6 per cent we experienced during the 20 years to 1994.

In other words, the main thing we have to explain is not an abysmal performance at present (after you allow for the special factors in mining and utilities) but why the unprecedented rate of improvement in multi-factor productivity during the 1990s wasn't sustained.

The authors' calculations confirm the recent slowdown in multi-factor productivity has occurred across virtually all market industries. So it's a general phenomenon.

The explanation favoured by many economists is that the surge in productivity was caused by all the microeconomic reform in the 1980s and early '90s. The subsequent fall-off, they say, is caused by the absence of further reform.

But the authors' examine other, alternative or complementary explanations. They note that "at a fundamental level, productivity is determined by the available technology (including the knowledge of production processes held by firms and individuals) and the way production is organised within firms and industries".

So a possible explanation for the surge and subsequent decline in multi-factor productivity improvement, they say, is the pattern of adoption of information and communications technologies.

Then there's the contribution to productivity from improved "human capital" - the education, training and skills of the workforce. One indicator of education and experience is the Bureau of Statistics measure of "quality-adjusted hours worked".

This has been growing at a consistently faster pace than the standard measure of hours worked since the 1980s, indicating that education and experience are likely to have made positive contributions to multi-factor productivity over this period.

However, the pace of growth of this measure has slowed, suggesting a smaller contribution from improving labour quality has played some role in the productivity slowdown.

Another, possibly contributory explanation for the slowdown in productivity improvement is that, over the course of the long economic expansion between the early '90s recession and the mild recession of 2008-09, the incentives for firms, workers and governments to implement productivity-enhancing changes gradually weakened. So broad-based economic prosperity has probably eased the pressures driving productivity improvements.

Most productivity-enhancing changes involve a degree of reorganisation than can be difficult for firms and workers. So without clear incentives for change there is unlikely to be a strong focus on enhancing productivity.

My conclusion from this thorough analysis of the problem is that we don't have a lot to worry about. That's because, first, when you dig into the figures you discover they're not nearly as bad as they look.

Second, the structural change now hitting so many of our industries is just the thing to (painfully) oblige them to lift their productivity.

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Banks facing structural change, too

As I'm sure you've gathered, a surprising number of our industries are going through a painful, job-shifting process economists euphemistically refer to as "structural adjustment". You've heard at length about the tribulations of mining, manufacturing, tourism, retailing, aviation, bookselling, newspapers and free-to-air television.

Then there's all the angst and words spilt by the media, politicians and people with mortgages over structural change in banking. Huh?

When people have been carrying on about how the banks have stopped moving mortgage interest rates in line with changes in the Reserve Bank's official interest rate, they've actually been complaining about just one consequence of the structural change that's being imposed on banks around the world in reaction to the devastation wrought by the (continuing) global financial crisis.

Just how the banks are being forced to change was explained by the deputy governor of the Reserve Bank, Dr Philip Lowe, in a speech last week (on which I'll be drawing heavily).

All of us can remember the halcyon days before the financial crisis when mortgage interest rates moved in lock step with the official rate. Unfortunately, they were only halcyon on the surface. Underneath, big trouble was brewing.

Particularly in the United States and Europe, there was a lot of cheap money flowing around, so the banks got quite slapdash about whom they lent to. They lent at interest rates that were artificially low, failing to reflect the riskiness of the project and the chance they wouldn't get their money back.

They also greatly increased their "gearing" - the ratio of borrowed money to shareholders' capital they used to finance their activities. When business is booming, becoming more highly geared accelerates the rate at which your profits grow. When business turns down, however, it hastens the rate at which profits shrink and turn to losses.

As we know, the day of reckoning did come, many banks in the US and Europe got into deep trouble and had to be bailed out by their governments to prevent them collapsing and causing a depression. Even so, the North Atlantic economies dropped into deep recession, from which they've yet to properly emerge.

In the meantime, the bank regulators and the global financial markets are forcing the world's banks to change their ways and lift their game - in short, to operate more safely, reducing the risk of getting into difficulties. Although our banks are well regulated and didn't get into bother, they're still affected by this tightening up.

Banks are now required to hold a higher proportion of their funds in shareholders' capital and a higher proportion of their assets in liquid form, making it easier for them to cope with a surge in depositors wanting to withdraw their money.

The financial crisis made Australians realise how dependent our banks had become on using short-term overseas borrowings to meet the needs of local home and business borrowers. Before the crisis the interest rates our banks paid on these foreign borrowings were unrealistically low; now they're much higher, to adequately reflect the risks involved.

Our authorities, and our sharemarket, have been pressing the banks to do their overseas borrowing over longer periods and raise a higher proportion of their funds from local depositors.

Do these efforts to make our banks safer and more crisis-proof sound like a good thing? They are. But, like everything in the economy, they come at a price.

What banks do is act as intermediaries between savers on the one hand and borrowers on the other. The costs they incur in performing this invaluable service (including the return on the shareholders' money invested in their business) are called the "cost of intermediation", which is the gap between the average interest rate they charge on the money they lend out and the average interest rate they pay to depositors and other lenders.

The cost of making our banks safer - by requiring them to hold higher proportions of share capital and liquid assets - has raised the cost of intermediation. Most of this higher cost has been passed on to the banks' mortgage and business borrowers.

The higher cost of borrowing abroad and borrowing from local depositors has also been passed on.

This explains why, since the early days of the financial crisis, the banks have been raising mortgage rates by more (or cutting them by less) than movements in the official interest rate. Over the 10 years to 2007, the variable mortgage rate averaged 1.5 percentage points above the official rate. Today, it's about 2.7 percentage points above.

That's what all the complaints have been about. Now you know why it's happened. But this bad news has been accompanied by three bits of good news which have had far less attention.

First, much of the increase in mortgage rates is explained by the very much higher rates being paid to depositors as the banks compete furiously for our money. Before the financial crisis, deposit rates were well below the official rate; now they're above it (particularly on internet accounts). Depositors outnumber people with mortgages by two to one.

Second, safer banks mean people who invest in bank shares (which is everyone with superannuation) are running lower risks - meaning their profits don't need to be as high. The boss of Westpac, Gail Kelly, said recently its return on shareholders' equity had fallen from 23 per cent before the crisis to 15 per cent.

Finally, to reduce the pressure on bank borrowers caused by the banks' now higher margin above the official rate, the Reserve Bank has cut it by about 1.5 percentage points below what it would otherwise be.

Structural adjustment is always painful - but there's always someone who's left better off.

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National productivity comes from firms' productivity

We've been debating what needs to be done to lift Australia's flagging productivity performance for a year, but only this week have we stopped using it in the unending political blame game and got down to some solid economic analysis.


The breakthrough came in a much-discussed speech Dr David Gruen, of Treasury, delivered to the annual Australian Conference of Economists in Melbourne.

Gruen made the apparently hugely controversial point that the primary responsibility for the productivity of the private sector - its output per unit of input - rests with the firms making up that sector and only secondarily with the government.

The government's role is in supporting the productive capability of the economy through investment in education and training, science and research, and infrastructure.

"Government involvement in these sectors is important," Gruen says. "Markets left to their own devices will tend to result in too little investment where there are social or spill-over benefits [in the jargon, 'positive externalities'] to the broader community beyond the returns available to a private investor.

"Governments influence the environment in which firms engage with each other and make investment and production decisions. They set the rules of the game, if you like, and affect the incentives that firms face, and their flexibility to respond."

But it's businesses that do the playing. So what do we know about the drivers of productivity improvement in the private sector? Well, a fair bit of empirical research has been done locally and overseas in recent years.

It shows that overall productivity improves in two different ways. One source is greater technical efficiency through innovation within the firm. Technical improvement comes about through research and development within the firm, or in partnership with the formal research sector.

But as a small country, most of the technology put into production in Australia is first developed overseas, Gruen says. A survey by the bureau of statistics shows only a small fraction of our innovative firms do things that are genuinely new to the world, or even new to Australia. Much more innovation is simply new to a particular industry.

"What usually distinguishes leading organisations is not so much their ability to create knowledge, but rather their ability to absorb technology developed elsewhere and apply it to their own circumstances," he says.

Why do firms innovate? According to the bureau's survey, three-quarters of innovative firms report undertaking innovation to improve profits. About 40 per cent also wanted to increase or maintain their market share and a quarter needed to develop products that were more competitively priced.

That's pretty much what you'd expect, but the second source of productivity gain is less obvious and less benign: it improves when production in an industry shifts from low-productivity firms to high-productivity firms.

A study of Australia firms in the 1990s found a remarkably wide range in their efficiency. The labour productivity of the most efficient firms was about four times that of the least efficient. Only about half this difference seems to be explained by differences in size.

So the productivity of an industry is improved when low-productivity firms are taken over or otherwise cease to exist, and also when new businesses with bright ideas start and grow.

Few people realise how much turnover there is of firms, even when the economy is growing strongly. According to figures from the bureau, about 8 per cent of firms close down each year. And about 40 per cent of new firms exit in less than four years.

Get this: overseas estimates suggest the net effect of the entry and exit of firms accounts for between a fifth and a half of the improvement in labour productivity over time. In high-technology industries, in particular, start-ups play an important role in promoting technological adoption and experimentation, Gruen says.

Hint to politicians: "Policies that act to slow the movement of resources will tend to limit this source of productivity improvement."

Another way to study productivity at the firm level is to look at management practices. Like productivity, management is about how well resources are used in production. So if you can rate particular management practices and give management teams a score, maybe this will help explain productivity differences across firms and even across countries.

One long-running study is doing this for 9000 medium and large manufacturing firms in 20 countries. It gives good ratings to firms that monitor what's going on in the firm and use this information for continuous improvement; set targets and track outcomes, and promote employees based on their performance.

The study shows management practices in Australia are mid-range: well below the United States, Germany, Sweden, Japan and Canada, but similar to France, Italy and Britain. And we have a larger tail of companies at the poor management end of the distribution compared with the US.

Looking at the performance of Australian firms, large manufacturers tend to be much better managed than small ones - a worry because our firms tend to be smaller than those in other countries. And it does seem clear better-managed firms are more innovative and have higher productivity.

Gruen argues periods of significant structural change - as at present - are often periods of growth and reform for the economy.

For a firm that's been doing the same thing for a long time, changes in business models are risky, difficult and may well require staff lay-offs. But when structural change means doing the same old thing is likely to be unprofitable, the opportunity cost of transforming work practices is substantially lowered. Structural change usually involves firms coming under greater competitive pressure. And tough competition and innovative activity seem to go together.

In Australia, firms that report having more competitors, that are in industries with low mark-ups, that export, or that experience downward pressure on profit margins are more likely to be innovators.

Case studies of Australian manufacturers hit by the reduction of import protection in the 1980s and '90s show the firms that succeeded did so by changing their practices. The number of plants diminished, plants became more specialised, model ranges were cut and world-best technology introduced.

Of course, some firms close down and leave the industry. But that's the harsh part of the lovely sounding productivity improvement: Competition boosts productivity partly by moving resources to more successful firms.

Get it? When politicians protect firms from closing, they risk stifling productivity improvement. For countries, comfortable and rich don't go together.

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Resources boom will lead to much bigger mining sector

A widespread fear - or maybe for some, a hope - is that the resources boom will evaporate someday soon. What will we do once it's over, a lot of people ask. Well, this week we got an answer: export at least twice the minerals and energy we do today.

You can divide the resources boom into three overlapping phases. The first phase is where the prices we receive for our exports of coal and iron ore shoot up to unprecedented levels because the world's exporters of those commodities are unprepared for the surge in demand from China and India as they rapidly industrialise.

The second phase is where our (and the world's) commodity producers seek to take advantage of those remarkable prices by expanding their production capacity as quickly as possible. At first the mining companies expand their existing mines, then they and others begin building new mines.

Much of the financial capital they require to fund this expansion comes from the retained after-tax earnings of the mining companies' shareholders (many of whom are foreigners). Much of the rest of the financial capital will be acquired from abroad. Much of the physical capital (mainly equipment) the miners install will be imported.

As part of the expansion, steps must be taken to ensure sufficient infrastructure exists to transport the minerals or natural gas to the nearest port by road or rail or pipeline, then loaded onto bulk carriers. Often this infrastructure is provided privately, sometimes it's provided by government.

The third phase is where the new production capacity comes on line and the volume of our exports starts to surge. But it won't just be us who are now exporting a lot more. The countries we compete with will also have been expanding their production capacity.

So even if you assume the demand for mineral and energy continues unabated - which is a reasonable expectation in this case - the global surge in supply can be expected to bring down the earlier sky-high prices.

Thus the prices we've been receiving for our exports are certain to fall back. Fortunately, however, this will occur as the volume of those exports is growing, thereby limiting the effect on the total value of our exports.

So, where do we stand in this process?

We've reached the point where, after a lot of global investment in new capacity, global supply has begun to expand and global prices have passed their peak and begun falling.

Thus our terms of trade - the prices we receive for our exports relative to the prices we pay for our imports - peaked in the September quarter and fell back in the two subsequent quarters. The terms-of-trade index (where 2009-10 equals 100) got to 130, but has since fallen by 10 per cent to 117.

Since it was the big improvement in our terms of trade that did most to explain the rise in our exchange rate, this deterioration in our terms of trade might explain why the dollar has fallen closer to parity with the US dollar. We can't be sure, however, because - as you might have noticed - a lot of other worries have been affecting global currency markets lately.

Similarly, although we can't be sure, most economists are confident global coal and iron ore prices won't fall back to where they were before the boom started, meaning our terms of trade will stay above their long-term average.

And, assisted by continuing strong capital inflow to Australia, the dollar will stay well above its post-float average of about US75?. (Meaning, of course, that life will stay uncomfortable for our other export and import-competing industries.)

This doesn't mean the second, investment phase of the boom is nearing its end, however. According to a Bureau of Statistics survey, the industry is expecting to spend a record $120 billion this financial year, up from $95 billion in the year just past.

Much mining investment comes under the heading of "engineering construction". It's expected to grow in real terms by more than 20 per cent in 2012-13 and by 9 per cent in 2013-14. The industry has committed to, or commenced construction on, more than half the fabled $456 billion resources-investment pipeline.

Note that much of the spending in recent times is on the development of liquefied natural gas facilities.

As for the third, export expansion phase, this week we got some new estimates from the Bureau of Resources and Energy Economics. It's expecting the volume of our total minerals and energy exports of about 700 million tonnes a year to more than double by 2025. And that's just the low-range estimate.

We now export about 400 million tonnes of iron ore a year. By 2025, this could grow to between 885 million and 1082 million tonnes. If so, our share of the world export market would go from its previous 30 per cent to between 45 and 55 per cent. Our main competitors are Brazil and West Africa.

At present we export about 20 million tonnes of natural gas a year, giving us just 2 per cent of the world export market. This could increase to between 86 million and 130 million tonnes by 2025, taking our market share to between 10 and 15 per cent. Our main competitors are Qatar, Russia and, in future, North America.

We are now exporting roughly 150 million tonnes of steaming (thermal) coal, giving us less than 20 per cent of the export market. This could rise to between 267 million and 383 million tonnes by 2025, taking our market share to between 23 and 33 per cent. Our competitors include Indonesia and, in future, Mongolia.

Our exports of coking (metallurgical) coal are roughly 150 million tonnes a year, but they could rise to between 260 million and 306 million tonnes. This would take our market share from 60 per cent to between 56 and 66 per cent. So there's a risk we lose market share to rivals such as Colombia.

All this growth isn't expected to much change the states' share of bulk commodity exports by volume. Western Australia has 60 per cent and Queensland has 22 per cent. But NSW has 15 per cent, leaving other states and territories with 3 per cent.

We'll be left with a mining sector whose share of national production (gross domestic product) well exceeds 10 per cent, making it bigger than manufacturing.

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The economy isn't a Sunday school - it often hurts

When I was a kid marbles were the rage. When you played at home with your brothers and sisters, mum made sure that, whoever won, everyone got their marbles back when the game was over. When you played at school, however, the big boys insisted on "playing for keeps", so kids like me went home with a lot fewer marbles.

I also went to Sunday school, which was run by kindly mothers. If you forgot to memorise your verse of scripture, there was no comeback. If you misbehaved there was no punishment, just a look of disappointment on the face of your teacher.

We've been hearing a lot lately about people losing their jobs. Firms in manufacturing, but also other industries, are announcing redundancies. There've been so many they could give you the impression employment is falling. Fortunately, it isn't; the people losing their jobs are being more than made up for by others gaining jobs (including people who lost their jobs earlier).

Sometimes people are laid off because the economy is in recession, but at present it's happening because powerful forces are changing the industrial structure of the economy. Older industries are shrinking while newer ones are expanding.

It must be a terrible thing to lose your job through no fault of your own, even if they do give you a fat cheque as they push you out. It's anxious waiting after an announcement to see if you'll be among those tapped on the shoulder. When "downsizing" was the fashion in the 1980s and '90s, it was said even those who kept their jobs suffered "survivor guilt".

When you're a victim of structural change - or just a feeling person looking on - it's tempting to look for someone to blame. Managers have been altogether too ruthless in protecting the business's bottom line; they took too long to recognise the problem and when they did respond they could have done it far better. The government should have stepped in to protect the industry.

Since managers are as subject to human frailty as ordinary employees (just extraordinarily more highly paid), there's often some truth to these criticisms - especially with the wisdom of hindsight.

If businesses weren't so quick on the trigger in laying off workers in the early stages of a downturn, fewer downturns would turn into full-blown recessions. If they were more imaginative and innovative they'd find less painful solutions to problems (they'd probably also anticipate a lot of problems that didn't materialise).

But when there are major changes in the forces bearing down on an industry, there's no point imagining change could have been resisted, nor any way that all human pain could have been avoided.

The economy isn't run like a Sunday school. In an economy like ours, everyone - bosses, workers, customers - pursues their self-interest. The economic game is played for keeps. So everyone runs a greater or lesser risk of losing their job. Even bosses get the bullet.

All of us act in self-regarding ways that, whether or not we realise it, contribute to someone's job insecurity. And that means a fair bit of uncertainty, anxiety, fear, disappointment, loss of status, self-doubt, frustration, family discord, despair, humiliation, depression, belt-tightening and worse are part of the deal.

Nor is the risk of pain fairly distributed. Some people never lose their job in a long career, some make the transition to a new job relatively easily, some move into retirement earlier than they'd bargained for, some have considerable difficulty finding another job, some never work again.

Perhaps the greatest force driving structural change is advances in technology - people inventing new products, new things to do or new ways of doing old things. The digital revolution is reshaping our economy - destroying jobs here, creating them there - in ways and to an extent we as yet see only dimly.

Does anyone suggest we should halt technological advance because of all the economic disruption it brings - and has brought since the days of the Luddites? Does anyone imagine such an attempt could work?

Another major force driving economic change is globalisation - the lowering of natural and government-made barriers between countries, caused by technological advance and, to a lesser extent, deregulation.

The historic re-emergence of the mighty economies of China and India - and the rapid economic development of the poor countries generally - is shifting jobs around the world.

Most rich countries are benefiting from cheaper imported manufactures (gains to consumers, but job losses in manufacturing), but Aussies are also benefiting from higher prices and quantities for our rural and mineral exports (increased income for the whole nation, but pressure for capital and labour to shift to mining).

Think the poor countries' pursuit of prosperity should be stopped because of the economic disruption it's causing? Think it could be?

For decades we tried to shut out change from the rest of the world by protecting particular industries. These days we use taxpayer subsidies. But jobs in particular industries can be protected only at the expense of jobs in the unprotected industries. Import restrictions and subsidies merely shift the job pressure (which never troubles the people demanding assistance).

When you're in the thick of it, it's easy to imagine structural change leads to ever-rising unemployment. But businesses have been installing new, "labour-saving" technology continuously for two centuries without it leading to mass unemployment.

Structural change doesn't reduce jobs overall, it destroys them in some industries and creates them in others.

Market economies deliver almost continuously rising material prosperity. But they do so by continually changing, and that change comes with a fair bit of pain for many people.

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Much change is structural, not cyclical

One of the first lessons economists teach us is that the economy moves in cycles of boom and bust. A second, trickier lesson is that although most of the changes going on in the economy at any moment are "cyclical" (temporary), there may also be changes driven by "structural" (longer-lasting) forces.

In a speech last week, Glenn Stevens, the governor of the Reserve Bank, implied that much of the "unrelentingly gloomy" public discussion about the economy may be caused by people mistaking structural problems for cyclical ones.

Despite the official statistics saying the economy's quite healthy, people think it's weak and want the economy's managers to get it moving by such standard remedies as a tax cut or a cut in interest rates.

But if the problem is structural - if it arises from deep-seated changes in the economic environment - such remedies will make little difference. Structural change is rarely painless - it often involves people losing their jobs and businesses failing - but it's almost always better to adapt to the way the world now works than try to resist it.

The boom in export prices and the construction of new mines arises from the historic re-emergence of the Chinese and Indian economies and is a classic example of structural change. The accompanying high dollar is helping to bring about a long-term shift of workers and capital into mining and away from manufacturing, tourism and overseas education.

But Stevens argues the resources boom is getting blamed for the problems of industries whose tough times are the product of a quite different source of structural adjustment: the markedly changed behaviour of Australian households. Consider his figuring.

In the mid-1970s, households began reducing the proportion of their disposable incomes they saved, meaning their spending was able to grow faster than their incomes. But this went into overdrive between 1995 and 2005.

Over that decade, households cut their rate of saving by a cumulative 5 percentage points. In consequence, their consumer spending grew at an average annual rate of 2.8 per cent per person, after allowing for inflation, even though their disposable incomes grew at a real annual rate of just 2.3 per cent per person.

Why did so many of us feel we no longer needed to save much of our income for use later on? Largely, it seems, because we saw ourselves getting wealthier as each year passed. The gross value of assets held by households - mainly the value of our homes - more than doubled between 1995 and 2007. That involved a real annual increase of more than 6 per cent per person.

Only a small part of this increase came from the building of additional homes. Most of it was just the rise in the prices of existing homes.

So why did housing prices rise so dramatically? Mainly because we went through a decade-long frenzy of competing with each other to move to better homes, which bid up prices.

In the process, of course, households took on a lot more debt, including for investment properties. Total household debt rose from 70 per cent of total annual household income in 1995 to about 150 per cent in 2007. This unprecedented "gearing up" by households was made possible by the deregulation of the banks and the return to low inflation and, hence, low mortgage interest rates.

All this borrowing couldn't have gone on forever, and households began to call a halt a year or two before the global financial crisis reached its peak in late 2008, after which they really began saving a lot more and trying to get on top of their debts.

While households were increasing their rate of saving, their consumer spending grew more slowly than their incomes. But their saving rate has been relatively stable - at a rate last seen in the 1980s - for about 18 months, meaning consumer spending has returned to growing at the same rate as incomes.

As part of our households' return to their former prudence, the rate at which homes change hands has fallen by a third from its average over the previous decade. And now the demand for housing has slackened, house prices have fallen back a bit. They won't keep falling forever, but nor are we ever likely to see them shooting up the way they used to.

The return of the prudent consumer is causing adjustment pains for various industries: the banks aren't doing as much business (I know your heart bleeds), nor are the real estate agents. State governments are getting a lot less revenue from conveyancing duty.

Last but not least are the retailers. The halcyon days of rapid growth in consumer spending are gone for good and they'll just have to get used to it. Those retailers selling the sorts of things people buy when they move into a new home are finding life a lot tougher.

But the end of the "platinum age" is just one source of structural change facing retailers. Another source is that retailers sell goods, but as each year passes, more of the consumer dollar goes on services and less on goods.

Yet another is the digital revolution. While shopping in one store, people are using their smartphones to check the prices being offered in rival stores, then demand they be matched. And the internet is giving people access to the cheaper prices charged by retailers in other countries.

None of these various structural changes are the fault of the government and there's little the managers of the economy can or should do to halt or even alleviate them. Business has little sensible choice but to adjust. In any case, most are for the better.

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All work creates wealth

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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