Treasury's opportunities and threats facing our economy

It shouldn't surprise you that when the secretary to the Treasury, Dr Martin Parkinson, devoted half his major speech this week to "fiscal sustainability" - the tax increases and spending cuts needed to get the budget back on track - the media virtually ignored the other half.

But the budget isn't the economy. And in that other half Parkinson offered a revealing SWOT analysis of the economy, outlining its Strengths and Weaknesses, Opportunities and Threats. So let me tell you what he said (and leave my critique for later).

For people worried about what we do for an encore after the resources boom - about where the jobs will come from - Parko points to three big "waves of opportunity".

The first wave is the mining investment boom, which is ending but not leaving us high and dry. "With the capital stock in the mining and energy sectors now triple what it was a decade ago, additional productive capacity will drive strong growth in resources exports for several years to come," he says, although this will involve employing fewer workers than in the investment phase.

The second opportunity wave flowing from the vast economic shifts in Asia is rising global demand for agricultural produce. The Australian Bureau of Agricultural and Resource Economics and Sciences estimates that China's imports of fruit will treble by 2050. Imports of beef will grow by a factor of 10 while imports of sheep and goat meat increase by a factor of 19. Dairy will increase by a mere 165 per cent.

Asia already takes more than 40 per cent of our food exports. Parko warns, however, that our ability to gain a slice of its rising demand rests on continued productivity gains in our rural sector, supported by the right policy settings.

"Our handling of the concerns raised by foreign ownership of Australian agricultural land (and food manufacturing) in some parts of our community is one dimension of the agricultural policy challenge, along with our approach to trade policy, stimulating investment in on- and off-farm infrastructure and supporting research and development."

The third wave is the opportunities in the services and high-value manufacturing sectors brought about by the steadily increasing growth of the Asian middle class. It's estimated that, by 2030, just under two-thirds of spending by the world's middle class will come from the Asia Pacific region, compared with about a quarter today.

"To capture the benefits of the third wave, we will need to compete on the global stage for Asian demand for services and high-end manufactures on the basis of both cost and quality," he says. "We will also need to compete for foreign direct investment to help put the right export-related infrastructure in the right places."

But get this declaration from the economic rationalist-in-chief: "Contrary to how it is sometimes portrayed in the media, competing on the global stage does not mean driving down wages or trading off our standard of living. Far from it."

Parko says improving Australia's competitiveness in global markets means investing in the skills of our workforce so Australians have the opportunity to move into sustainably higher paid jobs, and investing in infrastructure that has a high economic return.

It means ensuring firms and their employees are freed from unnecessary regulatory burdens, and establishing the right incentives to encourage innovation and competition. "In other words, it means raising Australia's productivity performance," he says.

Which brings us to Parkinson's three big threats to our further economic success. The first is productivity improvement. He says that, even after you allow for temporary factors, there's been a slowdown in "multi-factor" productivity improvement that's broad-based across industries, suggesting that deeper, economy-wide factors are at play.

The second threat arises because, until mid-2011, the effect of this productivity slowdown on the rise in our living standards was masked by the rise in the prices we were receiving for mineral exports. But now the likelihood that these prices will continue falling means a "significant drag on Australia's national income growth" over the rest of this decade.

The third threat to continued strong economic growth comes from the turnaround in the "demographic dividend" delivered by the baby boomers. For about 40 years until 2010, the proportion of the population of working age (here defined as 15 to 64) grew a lot faster than the overall population because of the postwar baby boom, followed by a dramatic fall in the birth rate in the 1960s and '70s. This boosted economic growth.

"Over the next few years, this demographic dividend, which has been fading for some time, will actually reverse. The proportion of the population aged 65 and over is expected to increase to nearly 20 per cent in 2030, from 13.5 per cent in 2010."

As the population ages, the total participation rate - the proportion of people 15 and over participating in the labour market - will fall, despite the increase in the participation rate among older Australians. "This expected decline has already begun and will become more pronounced by the end of the decade," he says.

Productivity is the key long-run driver of income growth, but declining export prices and labour-force participation are expected to subtract from national income growth in future.

If we assume the productivity of labour grows at its long-term average, then income per person would grow over the coming decade by about 0.7 per cent a year, about a third of the rate to which we've become accustomed, he says. To avoid that, we'd need to sustain labour productivity growth of about 3 per cent a year, about double the rate we've achieved so far this century.

If we fail to make the reforms needed to achieve that rate of productivity improvement, by 2024 our income per person will have risen only to $69,000 a year, not $82,000. We'll each be $13,000 a year less affluent than we could have been.

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We own as much of their farm as they own of ours

Did you know that, at the end of last year, the value of Australians' equity investments abroad exceeded the value of foreigners' equity investments in Australia by more than $23 billion?

It's the first time we've owned more of their businesses, shares and real estate ($891 billion worth) than they've owned of ours ($868 billion).

These days in economics there's an easy way to an exclusive: write about something no one else thinks is worth mentioning, the balance of payments. We'll start at the beginning and get to equity investment at the end.

Before our economists decided the current account deficit, the foreign debt and our overall foreign liability weren't worth worrying about, we established that, when measured as a percentage of national income (gross domestic product), the current account deficit moved through a cycle with a peak of about 6 per cent, a trough of about 3 per cent and a long-term average of about 4.5 per cent.

Those dimensions were a lot higher in the global era of floating exchange rates than they'd been in the era of fixed exchange rates (which ended by the early '80s). This worried a lot of people, until eventually economists decided the new currency regime meant there was less reason to worry.

This explains why economists haven't bothered to note that for four of the past five financial years, the figure for the current account deficit as a percentage of GDP has started with a 3. And, as we learnt earlier this month, the figure for the year to December was 2.9 per cent.

So it seems clear that recent years have seen a significant change in Australia's financial dealings with the rest of the world. And the consequence has been to lower the average level of the current account deficit.

The conventional way to account for this shift is to look for changes in exports, imports and the "net income deficit" - the amount by which our payments of interest and dividends to foreigners exceed their payments of interest and dividends to us.

The first part of the explanation is obvious: over the past decade, the world's been paying much higher prices for our exports of minerals and energy. This remains true even though those prices reached a peak in 2011 and have fallen since then.

On the other hand, the prices we've been paying for our imports have changed little over the period. So, taken in isolation, this improvement in our "terms of trade" is working to lower our trade deficit and, hence, the deficit on the current account.

Next, however, come changes in the quantity (volume) of our exports and imports. Here, over the full decade, the volume of imports has grown roughly twice as fast as growth in the volume of exports. Until the global financial crisis, we were living it up and buying lots of imported stuff. And maybe as much as half of all the money spent on expanding our mines and gas facilities went on imported equipment.

The more recent development, however, is that the completion of mines and gas facilities means enormous growth in the volume of our mineral exports - with a lot more to come. At the same time, as projects reach completion there's a big fall in imports of mining equipment. That's a double benefit to the trade balance and the current account deficit.

Turning to the net income deficit, it's been increased by the huge rise in mining companies' after-tax profits, about 80 per cent of which are owned by foreigners. Going the other way, world interest rates are now very low and likely to stay low.

Put all that together and it's not hard to see why current account deficits have been lower in the years since the financial crisis, nor hard to see they're likely to stay low and maybe go lower in the years ahead.

The current account deficit has to be funded either by net borrowing from foreigners or by net foreign "equity" investment in Australian businesses, shares or real estate. This means the current account deficit is the main contributor to growth in the levels of the national economy's net foreign debt, net foreign equity investment and their sum, our net foreign liabilities.

Historically, our high annual current account deficits worried people because they were leading to rapid growth in the levels of our net foreign debt and net total liabilities.

But looking back over the past decade, and measuring these two levels relative to the growing size of our economy (nominal GDP), there's no longer a clear upward trajectory. Indeed, it's possible to say our net foreign debt seems to have stabilised at about 50 per cent of GDP, with net total liabilities stabilising a little higher.

Over the decades, the level of net foreign equity investment in Australia has tended to fall as big Aussie firms become multinational by buying businesses abroad and Aussie super funds buy shares in foreign companies, thus helping to offset two centuries of mainly British, American, Japanese and now Chinese investment in Aussie businesses.

But the net total of such equity investment is surprisingly volatile from one quarter to the next, being affected not just by new equity investments in each direction, but also by "valuation effects" - the ups and downs of various sharemarkets around the world as well as the ups and downs in the Aussie dollar.

Between the end of September and the end of December, net foreign equity investment swung from a net liability of $27 billion to a net asset of $23 billion. This was mainly because of valuation effects rather than transactions, so I wouldn't get too excited.

What it proves is that, these days, the value our equity investments in the rest of the world isn't very different from the value of their equity investments in Oz.

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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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Trans-Pacific Partnership: we pay more for longer

According to someone called Oscar Ameringer, politics is the gentle art of getting votes from the poor and campaign funds from the rich, by promising to protect each from the other. However, when Tony Abbott spoke at the Business Council's 30th anniversary dinner last week, he was very much in protecting-big-business mode.

"On election night, not quite three months ago, I declared that Australia is under new management and once more open for business," he told the captains of industry. "My business - the business of government - should be making it easier for you to do your business because government doesn't create prosperity, business does.

"Governments' job is to make it easier for good businesses to do their best ... that's why almost everything we've done over the past three months has been to make it easier for Australians to do business."

It's possible, of course, that Abbott didn't really mean all that. Perhaps he was just greasing up business people because they were who he happened to be speaking to. Maybe next week he'll tell a bunch of consumers he's doing it all for them.

It's too early to tell just whose interests the Abbott government is seeking to advance. Maybe it doesn't yet know itself.

But I get a bit twitchy when I hear politicians running the line that what's good for General Motors is good for America.

I worry when I hear allegations that Australia bugged the cabinet room of a friendly nation not in the national interest but in the interest of a particular Australian company. Then that one of the politicians at the time has since become an adviser to the company.

I confess to being concerned about what deal Trade Minister Andrew Robb is doing in our name at the Trans-Pacific Partnership negotiations in Singapore this week.

The partnership is a trade treaty the US wants with 11 other Pacific rim countries: Canada and Mexico, Chile and Peru, Australia and New Zealand, Japan and Malaysia, Singapore, Brunei and Vietnam.

The US has been negotiating the treaty since 2006 in what it has insisted be complete secrecy. Although it has no doubt been consulting with its own big companies, and it's a safe bet our business lobby groups have been briefed about the contents of the treaty and have advised our government on their views and goals, the rest of us aren't meant to know what's going on.

Parliament will have to be told the content of the done deal before it votes to ratify any treaty the government has agreed to, but that's all. It's "need to know" and you, dear voter, don't need to know. Leave it to the adults.

Well, not quite. Last month one of the draft treaty's 29 chapters, on intellectual property, was published by WikiLeaks.

This week one country's detailed description of the state of negotiations was leaked. So we know a fair bit about what we're not supposed to know. And what we know isn't terribly reassuring.

What I know about the US government's approach to trade agreements - which doesn't seem to have changed since the deceptively named free-trade agreement we made with it in 2004 - is that its primary objective is to make the world a kinder, safer place for America's chief export, intellectual property: patents, copyright and trademarks - in the form of pharmaceuticals, films, books, software, music and much else.

To this end, the length of copyright would be extended beyond the 70 years to which it has already been extended, and copyright infringement would be made a criminal offence. It would be made easier for pharmaceutical companies to artificially extend the life of their patents and frustrate the activities of others wishing to produce generic versions.

It is clear this would greatly benefit America's big entertainment, software and drug companies.
What's equally clear is that it has no economic justification, being simple "rent-seeking"; government intervention in markets to enhance the profits of particular companies.Rupert Murdoch's 21st Century Fox would be a prime beneficiary.

Since Australia is a net importer of intellectual property, our government ought to be in no doubt the Americans' demands are contrary to our economic interests.

The leaks reveal many dubious demands by the US, but none more so than its promotion of "investor-state dispute settlement" provisions, which would allow foreign companies to pursue legal actions against our government in foreign tribunals if, for example, it were to introduce policies they considered contrary to their interests.

This would give foreign companies an advantage local companies didn't have. The Productivity Commission found such provisions offered few benefits, but considerable policy and financials risks. The former Labor government had a blanket ban on agreeing to such clauses, but Robb's approach is more flexible.

Why would any country agree to such unreasonable demands? Because, in exchange, the Americans are holding out the promise of greatly enhanced access to their markets - in our case, for sugar and beef.

So what we're not supposed to know is that, if the rest of us get sold out, it will all be in aid of Australian farmers. The trouble with running the economy to benefit business is you end up harming some to help others.

But not to worry. The leaks suggest agreement on the treaty is a long way off.

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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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Underneath, the economy is slowing

THE world is a complicated place - and the Bureau of Statistics' national accounts are more so. Sometimes they're better than they look, but the figures we got this week aren't as good as they look. On their face, they say real gross domestic product grew by 3.1 per cent over the year to December.

Since the economy's trend (medium-term average) rate of growth is about 3.25 per cent a year, that doesn't look too bad. The worry is, a lot more than half that growth occurred in the first half of the year, with growth in the last quarter of just 0.6 per cent - suggesting the economy is slowing.

The figures are unlikely to prompt the Reserve Bank to make much change to its forecasts last month of growth of just 2.5 per cent over the year to June, and probably not much better by the end of this year.

Looking into the detail, although consumer spending has generally held up better in recent years than many people suppose, it grew by a weak 0.2 per cent in the December quarter, and no better the quarter before.

Just why consumption has been so weak of late is a puzzle. The problem hasn't been weak growth in household incomes, nor a rise in the rate of household saving, which has been roughly steady at 10 per cent of household disposable income. It's the "disposable" bit that has been the problem: an unexplained increase in tax payments.

There was strong growth in the quarter in purchases of food and motor vehicles (for the year, up a remarkable 23 per cent), but a fall in spending at hotels, cafes and restaurants.

Probably the best news is that home building activity increased 2.1 per cent in the quarter, its best growth since early 2011, following a pick-up in the September quarter.

This suggests housing is finally starting to grow again, stimulated by lower interest rates and slowly rising house prices. But no one's expecting the recovery to be strong.

On the face of it, business investment spending contracted in the quarter, whereas public sector spending grew surprisingly strongly. But both results were distorted by the sale of an existing asset from the private sector to a state public corporation. Kieran Davies, of Barclays Bank, believes this is the Victorian government's purchase of a desalination plant for up to $4 billion.

As best he can untangle the figures, business investment rose 1 per cent during the quarter, while public sector spending was pretty flat. The latter's not surprising since governments at all levels are struggling to get their budgets back to surplus.

Within the overall growth in business investment, spending by the mining industries continued very strong, whereas spending by all other industries was weak.

According to the latest estimate by the Bureau of Resources and Energy Economics, the pipeline of committed resource projects is a record $268 billion. This suggests the peak in mining investment remains some quarters off and that, even when it arrives, it may be more of a plateau than the start of a dive.

While we're on the resources boom, the next notable feature of the accounts was that the volume (quantity) of exports grew 3.3 per cent during the quarter, whereas import volumes grew just 0.7 per cent. This means "net exports" (exports minus imports) made a contribution to overall GDP growth of 0.6 percentage points. By far the strongest growth came from coal and iron ore exports.

But a slowing in the rate of inventory accumulation made a negative contribution of 0.4 percentage points and, as Dr Chris Caton of BT Financial Group has calculated, almost all of this came from a sharp decline in mining inventories. It thus makes sense to say mining exports made a net contribution to growth of 0.2 or 0.3 percentage points.

So it's a mistake to say, as some have, that mining accounted for all the growth in the quarter. Small contributions came from consumer spending and housing. And it's good to see signs of the third phase of the resources boom getting started: there's a lot more growth in the volume of our mineral exports to come.

This is the time to be clear on the distinction between export volumes and export prices. Even as export volumes are growing, export prices are falling. Indeed, prices are falling mainly because volumes are growing. That is, prices are falling as supply catches up with demand.

The fall in export prices relative to import prices caused our "terms of trade" to deteriorate by 2.7 per cent during the quarter (and by 12.9 per cent during the year). This explains why, though real gross domestic production grew 3.1 per cent over the year, real gross domestic income rose by just 0.2 per cent.

This weaker growth in national income feeds through to business profits and household incomes, thus acting as a dampener on spending. And this, plus the coming peak in mining investment (and despite the income we'll get from growing mining export volumes) explains why what we need to see now is a transition from mining-led growth to growth in the rest of the economy: consumption, housing and non-mining business investment spending.

That's what's disappointing about this week's seemingly OK national accounts: as yet, not much evidence the transition is occurring. It's being spurred on by the fall in interest rates over the past year or more, but held back by the continuing high dollar.

Even so, Wayne Swan is right to remind us that, whatever our troubles, they pale into insignificance compared with the troubles of most of the rest of the developed economies.

Our growth of 3.1 per cent is faster than almost all the other countries in the Organisation for Economic Co-operation and Development and more than four times the average. Of the 27 advanced economies, 15 actually contracted in the December quarter.

Our real GDP has grown by 13 per cent in the five years since December 2007. Among the seven biggest advanced economies, only Germany, the US and Canada can claim to have grown in that time. And the best of them - Canada - has grown much less than half as much as we have.

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Economy slowing, not dying

To hear many people talk, the economy is in really terrible shape. Trouble is, we've been waiting ages for this to show up in the official figures, but it hasn't. This week's national accounts for the September quarter are no exception.

You could be forgiven for not realising this, however, because some parts of the media weren't able resist the temptation to represent the figures as much gloomier than they were.

One prominent economist was quoted (misquoted, I trust) as inventing his own bizarre definition of recession so as to conclude the economy was in recession for the first nine months of this year.

Really? Even though figures we got the next day showed employment grew by 1.1 per cent over the year to November, leaving the unemployment rate unchanged at 5.2 per cent? Some recession.

What the national accounts did show - particularly when you put them together with other indicators - is that the economy is in the process of slowing, from about its medium-term trend growth rate of 3.25 per cent a year to something a bit below trend.

That's not particularly good news - it suggests unemployment is likely to rise somewhat - but it hardly counts as an economy in really terrible shape.

The accounts show real gross domestic product growing by 0.5 per cent in the September quarter and by 3.1 per cent over the year to September - which latter is "about trend".

This quarterly growth of 0.5 per cent follows growth of 0.6 per cent in the previous quarter and 1.3 per cent the quarter before that. So that looks like the economy's slowing - although the figures bounce around so much from quarter to quarter it's not wise to take them too literally.

But the accounts contain a warning things may slow further. We always focus on the growth in real gross domestic product, which is the quantity of goods and services produced during the period (and is the biggest influence over employment and unemployment).

But if you adjust GDP to take account of the change in Australia's terms of trade with the rest of the world, to give a better measure of our real income, you find "real gross domestic income" fell by 0.4 per cent in the quarter to show virtually no growth over the year.

Leaving other factors aside, this suggests our spending won't be growing as fast next year, leading to slower growth in the production of goods and services (real GDP) and thus slowly rising unemployment.

Our terms of trade are falling back from their record favourable level because of the fall in coal and iron ore export prices as the first stage of the three-stage resources boom ends. (The second stage is the mining investment boom and the third is the rapid growth in the quantity of our mineral exports.)

For some time the econocrats and other worthies have been reminding us that, when ever-rising export prices are no longer boosting our incomes, we'll be back to relying on improved productivity - output per unit in input - to lift our real incomes each year.

This makes it surprising we've heard so little about the figures showing that GDP per hour worked rose by 0.7 per cent in the quarter and by a remarkable 3.3 per cent over the year. Again, it's dangerous to take short-term productivity figures too literally, but at least they're pointing in the right direction.

They also put a big question mark over all the agonising we've heard about our terrible productivity performance.

This week's figures confirm what we know: some parts of the economy are doing much worse than others. Business investment in plant and construction rose by 2.6 per cent in the quarter and 11.4 per cent over the year - though most of this came from mining, with investment by the rest of business pretty weak.

One area that isn't as weak as advertised is consumer spending, up by 0.3 per cent in the quarter and 3.3 per cent over the year - about its trend rate. The household saving rate seems to have reached a plateau at about 10 per cent of disposable income, meaning spending is growing in line with income.

Investment in home building grew 3.7 per cent in the quarter, suggesting its chronic weakness may be ending, thanks to the big fall in interest rates. Adding in home alterations, total dwelling investment was up 0.7 per cent in the quarter, though still down 6.3 per cent over the year.

The volume (quantity) of exports rose 0.8 per cent in the quarter and 4.7 per cent over the year, whereas the volume of imports rose 0.1 per cent and 3.5 per cent, meaning "net exports" (exports minus imports) are at last making a positive contribution to growth. This suggests we're starting to gain from the third stage of the resources boom, growth in the volume of mineral exports. The greatest area of weakness was spending by governments. Government consumption spending was down 0.4 per cent in the quarter (but still up 3.5 per cent over the year). Government investment spending fell 8.2 per cent in the quarter and 7 per cent over the year even though, within this, investment spending by government-owned businesses was strong.

All told, the public sector made a negative contribution to GDP growth of 0.5 percentage points in the quarter, and a positive contribution of just 0.3 per cent over the year - obviously the consequence of budgetary tightening at both federal and state levels.

This degree of contraction isn't likely to continue. But a strong reason for accepting the economy is slowing somewhat is the news from the labour market.

Don't be fooled by the monthly farce in which unemployment is said to jump one month and fall the next. If you're sensible and use the smoothed "trend estimates" you see unemployment steady at 5.3 per cent since August.

Even so, the economy hasn't been growing fast enough to employ all the extra people wanting work, causing the working-age population's rate of participation in the labour force to fall by 0.4 percentage points to 65.1 per cent.

And we know from the labour market's forward-looking or "leading" indicators - surveys of job vacancies - that employment growth is likely to be weaker in coming months.

That's hardly good, but it ain't the disaster some people are painting.

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GLOBALISATION - the importance of an economically literate Australia

Business Educators Australasia Conference, Sydney, Thursday, October 4, 2012

Just as the media have lost interest in talking about globalisation it’s starting to have big effects on Australia and on the daily lives of Australians. Often, the consequences of globalisation are buried too deep to be visible to the untrained eye, but that doesn’t change the reality. Why are overseas holidays a lot cheaper these days? Why are a lot of factories laying off workers? Why have the banks started putting up interest rates off their own bat, or not passing on all of the cuts in rates? Why isn’t my super doing as well as it used to? Why are the retailers always complaining? Why do the mining companies keep running all those ads telling us what great guys they are?

The short answer to all those questions is ‘globalisation’. Whenever something changes in Australia we have a tendency to look around us for an explanation. Increasingly, however, the explanation comes from elsewhere in the world. If we want to understand what’s happening to our lives - the forces shaping our lives - we need to understand globalisation: what it is, what’s driving it, how it affects us and where it’s taking us. To be economically literate - to have an understanding of what’s going on - Australians need to understand the process of globalisation. For many of our students, high school is the main chance they’ll have to learn about a largely invisible force that’s influencing their present and their future.

What is globalisation?

Globalisation is a process - a process by which the natural and human-made barriers between countries are being reduced. The natural barriers of time and space are being reduced by advances in technology, particularly the information and communications technology revolution. The human-made barriers between countries are being reduced by deregulation - governments pulling down or greatly liberalising the rules and regulations they have made to keep their economy separate from other economies. Sometimes governments pull down their barriers because advances in technology have made it easy to get around them. The point is that, as the barriers between countries and national economies are reduced, more of the forces changing our lives are coming from abroad.

The back story

I suppose you could say the process of globalisation began with the first trade between countries, by ship or on the Silk Road. But it’s generally held that the first wave of globalisation began in the late 19th century, with the spread of steel-hulled steamships, mass migration to the New World and the invention of the telegraph and laying of undersea cables. This first wave was brought to a halt by World War I and reversed by the protectionist reaction to the Great Depression.

The second wave began slowly after World War II, with the successive rounds of reductions in import duties and restrictions on trade under the General Agreement on Tariffs and Trade, developments in transport (including invention of the jumbo jet), information processing and telecommunications, the development of offshore financial markets and the advent of the multinational company.

At first the great increase in trade was between the developed countries themselves. But then the developing countries - particularly in Asia - began switching their development strategies from ‘import replacement’ (attempting to develop manufacturing sectors behind high barriers to imports) to export-led growth. Developing countries began lowering their protection, and the last round of multilateral reductions in import restrictions under the GATT - the Uruguay round of 1994 - saw many developing countries (including China) joining the newly formed World Trade Organisation.

The emerging economies

The greatly increased trade and flows of foreign direct investment between the developed and developing countries led to strong growth in many developing countries - particularly in Asia. Multinational companies set up manufacturing operations in these countries and transferred the latest technology, effectively spreading the industrial revolution and fostering rapid industrialisation and urbanisation. The most rapidly advancing economies - which are moving from poor to middle-income - are now referred to as ‘emerging economies’. Some countries - including South Korea and Singapore - are now classed among the high-income countries, as developed rather than developing.

Before the industrial revolution began in Europe in the late 18th century, the two biggest economies were China and India. That was on the strength of their big populations. Because China and India remain the two most populous countries, and because their economic emergence began earlier than many other developing countries, their development is shifting the world’s centre of economic gravity from the North Atlantic (America and Europe) towards Asia.

The standard pattern of economic development established in Asia in the decades since World War II has been the production for export of simple, labour-intensive manufactures such as textiles, clothing and footwear, taking advantage of the main thing the poor countries have to offer the world: an abundance of poorly educated but cheap labour. As this early trade starts to lift national income, the level of education and skill rises and the country progresses to producing more elaborately transformed manufactures. Although some people in rich countries imagine it’s not happening, education, skills and national income rise and so do real wage levels. Eventually, labour becomes too expensive for the country to continue producing simple, labour-intensive manufactures, so this production moves to other poor countries that are just starting out on the road to development. Countries that export also have to import; they tend to import those raw materials they don’t produce domestically and capital equipment for further economic development. Initially, economic development probably adds to income inequality in the emerging economies, even while lifting many people out of absolute poverty. Eventually, however, rising real wage rates should work to reduce inequality.

Changing world trade patterns

Historically, the developed countries have been importers of raw materials - food, fibre, minerals and energy - and exporters of manufactures. Much of the growth in their trade with each other since the war has been based on high levels of specialisation - ‘intra-industry trade’ (eg trade between the car makers in different countries) rather than on comparative advantage. Most of their economic growth has come from growth in their services industries - health, education, business services, culture and recreation - most of which hasn’t involved overseas trade.

With the rise of the emerging economies and particularly China, however, much of the world’s manufacturing activity is moving to Asia, causing manufacturing to contract in developed economies and faster growth in their sophisticated services sectors. But the ICT revolution is also making it possible for some services to be traded between countries. Initially this has involved the ‘outsourcing’ of fairly menial jobs such as call centres and data processing, but it is growing to include such high-end services as software development and sub-editing.

Many people in the developed economies are alarmed by the shift of jobs in manufacturing and services to the cheap-labour countries. They see it as a loss with no corresponding gain. Some have even convinced themselves there’s no gain to the cheap-labour countries because multinationals appropriate all the profits. They imagine that because we would not want to work for such pay and conditions, workers in the poor countries are being exploited and gain little. In truth, the poor countries gain greatly from their export income and local workers are keen to get a job and earn an income, particularly the generally better-paying jobs offered by foreign multinationals.

The gains from trade are mutual, though not necessarily equal. Rich countries (and their workers) gain from their access to cheaper manufactures and services, and also from their access to bigger markets for their exports. This is not to deny that the outsourcing of jobs causes pain to workers displaced from their jobs and needing to find new ones, nor that the benefits from trade with poor countries may be shared unequally.

Emerging economies take the running

For many decades, the United States and the other developed countries made the running for the global economy; their growth largely determined the world’s growth. Now, however, China, India and the other emerging economies have expanded to the point where they account for more than half of gross world product (when countries’ GDPs are combined after adjusting to achieve purchasing power parity), and for at least a decade their growth has accounted for most of the annual growth in gross world product. With the North Atlantic economies still mired by the GFC, this is likely to become even truer for at least the rest of the decade, which will hasten the shift in the world’s economic centre towards Asia. Similarly, whereas the cycle in world commodity prices used to be driven by the North Atlantic economies’ economic cycle, now Asia’s cycle - and its more structural demand - will drive.

Australia and the rise of Asia

Whereas the usual pattern is for developed countries to import raw materials and export manufactures, Australia’s huge endowment of national resources means for us it has always been the other way round: we tend to mainly export rural and mineral commodities and mainly import manufactures. For most of the 20th century it looked like we were getting the losing end of the stick. World trade in commodities wasn’t growing much and prices were stagnant, whereas trade in manufactures was growing strongly with ever-rising prices. About the time of the Sydney Olympics, in 2000, it was fashionable for foreign businessmen to condemn us as an ‘old’ economy.

What changed all that was the emergence of the Asian economies, led by China. When countries start to develop they require huge amounts of steel - to make exports but also for building factories, railways, bridges, buildings and even roads. When their consumers become more prosperous they want to buy appliances and cars made of steel. It just so happens that Australia is one of the world’s chief producers and exporters of the two main components of steel: iron ore and coking coal. China’s booming demand for coal and iron ore caught the world’s producers off guard, causing global demand to outstrip global supply, forcing prices up to unknown heights. The main commodity exporters are now rushing to expand supply. As they do prices will fall back.

Since the early noughties we’ve been selling China and India ever-growing quantities of iron ore and coking coal, plus steaming coal for use in power stations, all at exceptionally high prices. This is the origin of our resources boom which, as prices start to fall back, is continuing in a boom of investment in the construction of new mines and natural gas facilities. As this additional production capacity comes on line, the volume (quantity) of our exports of coal and iron ore will be expanding, even as the prices we get for them ease back.

Studies of the stages in the economic development of other, now-developed Asian economies - such as Japan and South Korea - suggest the period during which a rapidly developing economy needs exceptional amounts of steel can last for 20 or 30 years. This explains why the resources boom is regarded as more structural (lasting) than cyclical (temporary). It also explains why the lasting increase in demand for our mineral and energy exports will bring about a change in the industrial structure of our economy. The mining industry will account for a significantly higher proportion of GDP, and its expansion will attract labour and capital from other Australian industries, whose share of GDP will decline.

The rise in the value of the dollar, which has accompanied the rise in the export prices we receive, has worsened the international price competitiveness of our export and import-competing industries, particularly manufacturing, but also tourism and the education of international students. This has the effect of reducing those industries’ sales and profits. Some manufacturers have been hit hard, with factories closing and workers being laid off. The manufacturers are demanding additional government assistance, and get much sympathy from the public. But economists point out that the high dollar and its contractionary effect on manufacturing is actually part of the market mechanism that is helping to shift resources from the contracting manufacturing to the expanding mining. This, of course, doesn’t stop the process being very painful for the manufacturers and their workers.

The high dollar is one of the main ways ordinary Australians are benefitting from the resources boom. It is redistributing income from the miners to all those firms and consumers who buy (the now-cheaper) imports. Everyone who has taken advantage of the strong dollar to go on an overseas holiday is sharing in the benefits from the resources boom, whether or not they realise it. Even so, because the miners are doing so well from the boom they have been seeking to reduce public resentment of their good fortune by running advertisements pointing to all the good things they are doing in the community.

As China and India develop economically they are acquiring a larger and prosperous middle class, which is expected to grow considerably over the next 20 years. The growth of Asia’s middle class will increase the opportunity for greater Australian exports to Asia of food (meat, wheat and dairy products), manufactures and tourism.

The digital revolution

No technological development has done more to break down the barriers between countries than the digital revolution, particularly the spread of the internet, which is now being accessed more easily via tablet devices and smart phones. This is greatly benefitting the users of the internet, but is forcing considerable structural change on many industries.

The internet has undermined the ‘business models’ - the traditional way of selling products - of the music industry, film and television and, with the advent of the e-book, publishing and bookselling. The newspaper industry is being turned on its head by the shift of classified and display advertising and news to the internet and other digital ‘platforms’. The internet is also making many formerly non-tradable services tradable.

The retail industry is being hit and forced to change by a host of different forces: the end of the period in which households were reducing their rate of saving, thus allowing consumer spending to grow faster than household incomes; and consumers’ preferences shifting from goods to services. But the biggest challenge is coming from the digital revolution. People are using their smart phones in stores to compare prices with those offered by other stores and then demand discounts. And people are using the internet to buy online, including from overseas sites. This is not yet having a big effect on retailers, but it will in coming years. Retailers complain that people buying on the internet usually avoid having to pay the GST, and that the high dollar is making overseas prices more attractive. But these are not their biggest problem. It’s that multinational companies are used to selling identical books, CDs, DVDs, software, shoes and many other things at different prices in different countries. That is, for many years many big companies have engaged in international price discrimination, generally charging much lower prices in America than in Britain, with highest prices in Australia. The internet is breaking down this discrimination and will eventually force down many Australian prices.

Financial integration

Since the 1980s, reductions in the cost of telecommunications and deregulation have been turning the many national financial markets increasingly into one big set of global financial markets. As part of this, most developed countries have floating exchange rates, with the level of those exchange rates now affected less by trade flows (the current account of the balance of payments) and more by short-term capital flows (the capital account). This has increased the frequency of financial crises, such as the Asian financial crisis of 1997-98 and the global financial crisis of 2008-09.

Greater financial integration added to the severity of the GFC and the speed with which it spread around the world. While the crisis was centred on America’s sub-prime home loan debacle, it turned out many of these toxic assets had been bought by European banks. The globalisation of the media meant news of bank failures in the US, Britain or Europe was beamed into living rooms in all the countries of the world, almost in real time. This frightening news caused an instantaneous slump in business and consumer confidence in virtually every country, including many not directly affected by the crisis, such as Australian and China and the other emerging economies.

World recessions are usually sequential - some countries are still going in while others are coming out - thus making them less severe. But the world recession precipitated by the financial crisis was highly synchronised because of the integration of global financial markets and the globalisation of the news media. This contributed to the severity of the recession.

The greater integration of financial markets has increased the likelihood of ‘contagion’ - when one country gets itself into difficulty, this may cause the financial markets to lose confidence in neighbouring countries, whether or not they have the same degree of problems as the original country. After the tiny Greek economy got into difficulties within the euro area, European officials worried the market’s loss of confidence could spread to Portugal, Spain and even Italy.

Globalisation has increased the number of ‘channels’ through which economic difficulties in one country are transmitted to other countries. Formerly, the main channel was international trade. Now there’s a financial channel, where problems with the finances of one country lead to a global rise risk premiums, increasing borrowing costs in many other countries. And there’s a psychological channel, where bad news from one part of the world can damage business and consumer confidence in other countries, even those not directly affected.

The GFC and its aftermath in the US and Europe have had a big effect on our banks, even though they had been tightly supervised by our authorities and held few of the assets that became toxic. The world’s central banks have tightened their rules for the world’s banks, requiring them to hold higher proportions of shareholders’ capital and higher proportions of their funds in liquid form. This has increased the costs facing our banks along with other countries’ banks. Before the GFC, our banks obtained a high proportion of the funds they needed to relend to Australian customers from short-term borrowing in overseas markets. At the time, these funds were very cheap. But their price increased greatly as a result of the crisis. After the crisis, our authorities realised our banks’ heavy reliance on short-term foreign borrowing made them vulnerable to further international crises. So they required the banks to borrow for longer periods overseas and to rely more on domestic deposits. The greater competition between our banks to attract local deposits has greatly increased the interest rates they have to pay on those deposits (to the benefit of Australian savers). They’ve also had to pay more for their longer-term foreign borrowings. This has increased our banks’ cost of borrowed funds quite independently of changes in the official cash rate. And it explains why the banks have been increasing their rates without reference to the cash rate and cutting rates by less than the full fall in the official rate. The Reserve Bank has retained its control over market interest rates by cutting its cash rate by more than it otherwise would have.

Our sharemarket is another of the financial markets that has become more globally integrated in recent decades. Being one of the first markets to open each morning, it takes its lead from what happened on Wall Street overnight. You would hope that, eventually, the value of an Australian company’s shares will reflect that company’s own prospects. In the short-term, however, our market tends to reflect the worries of investors in Wall Street and Europe. And the prospects for those economies are not bright at present.

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Economy slows though consumers spend

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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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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How to blow the boom: cocoon manufacturers

The fusspots are right when they say we must make sure the nation gains lasting benefit from the resources boom. But doing so is as much about what we shouldn't do as what we should.

The first thing to note is that, even if the boom were to end a lot earlier than the policy-makers expect, the main thing we will be left with is a very much larger mining sector, producing and exporting a lot more minerals and natural gas than we do at present - and earning a good living in the process.

The sceptics who fear we'll be left with nothing when the present sky-high prices fall back - as they will - need reminding that higher prices are just one way to make a quid. The other way is with increased volume. And that is what we'll end up with.

Mining will account for a lot higher proportion of gross domestic product than its present 9 per cent. It is true that, mining being so highly capital-intensive, its share of total employment is likely to be just a few per cent.

It is true - but irrelevant. What matters is how much income mining brings into the country. When that income is spent - by the companies, their employees, governments and shareholders - jobs are created somewhere in the economy. Where exactly? In the services sector, where else?

Those who worry about us suffering Dutch disease - in which the high exchange rate caused by a minerals boom wipes out the manufacturing sector, leaving us with nothing when the boom's over - are themselves suffering from various misconceptions.

For a start, as a matter of historical accuracy, the manufacturing industry in the Netherlands wasn't wiped out in the 1970s and is alive and kicking to this day. Industries are invariably more resilient than they fear they will be - especially when seeking special assistance from governments.

Next, we need to avoid the mercantilist fallacy that the only way to make a living is to sell things to foreigners. At least three-quarters of our workforce makes its living selling things to other Australians. The only reason we need exports is to pay for imports - but the money earnt by the miners will help us with that.

We also need to avoid the physiocratic fallacy that the only way to make a living is to produce something that can be touched. If that is true, please explain how the three-quarters of the workforce toiling in the services sector - from the Prime Minister down to the lowliest cleaner - make their living.

We won't wipe out our manufacturing sector but even if we did, there is no shred of doubt where the jobs would come from: the same place all the extra jobs created in the past 40 years have come from - the services sector.

Yet another point to remember is that, with the economy already close to full employment in the early stages of the resumption of the resources boom, and with the ageing of the population causing the demand for labour to outstrip the supply of it, the one thing we won't have to worry about in coming years is: ''Where will the jobs come from?''

No, the problem here is not the threat of mass unemployment; it's just the matter of making sure we don't pee too much of the proceeds of our resources' good fortune up against a wall.

Why is that a worry? Because that is what we've done in the past.

In terms of export income, our economy has been riding on a sheep's back or on a coal truck since its earliest days.

What we've never had is a vibrant manufacturing sector. Our economy has been too small to get sufficient economies of scale, too far from North Atlantic markets and too good at mining and agriculture (by definition, you can't have a comparative advantage in everything).

But, for most of the past century, we hankered after a big manufacturing sector like all the other rich countries had. So we erected huge tariff barriers and set up a manufacturing industry behind them, thus forcing Australians to pay a lot more for their manufactures than they could have paid had they been given access to cheaper imports.

In other words, we took a fair bit of the proceeds from our rural and mineral wealth and used it to cross-subsidise a manufacturing sector far bigger than could have stood on its own feet. And now, with all the cries about the high exchange rate, we are being asked to do it again.

Since old-style protection in the form of tariffs and import quotas is now so unfashionable, the industry's lobbyists - including its unions - are pushing for disguised protection in the form of tighter anti-dumping restrictions and handouts in the name of ''innovation''.

There is no denying our manufacturers will need to be - and will be - innovative in their efforts to survive in an era of high exchange rates. But the more governments yield to rent seeking by pretending to be subsidising ''innovation'', the longer it will take the industry to accept responsibility for its own destiny.

No, if ever there is a time when it is obviously stupid for rich countries to prop up their manufacturers against competition from developing Asia, it is now.

The obvious way to maximise our lasting benefits from the resources boom is to let secondary industry take its chances and put all our effort into boosting tertiary industry - with all its clean, safe, well-paid, high value-added and intellectually satisfying jobs.

And the obvious way to do that is to invest in a lot more education and training, thereby increasing the nation's human capital and the saleability of Australians' labour.

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Raising the bar on the dollar's change in fortune

You may not have noticed, but the econocrats have raised the bar on the amount of economics you need to know to follow the debate about the economy - or, at least, to follow what they are saying about it. The jargon phrase of the year is the "real" exchange rate.

Until recently, heavies from Treasury and the Reserve Bank were content just to say the exchange rate - the overseas value of the Australian dollar - had depreciated (gone down) or appreciated (gone up) by a certain amount.

This was a reference to the "nominal" exchange rate - the one they tell you about at the end of a news bulletin, the one you can find in the business pages and the one your bank will use if you want to change some Aussie dollars into US dollars, euros or whatever.

As its name implies, the "real" exchange rate is the nominal exchange rate adjusted for inflation. But it's not just our inflation rate that comes into the calculation, it's our rate relative to the inflation rate of the country whose currency we're exchanging for the Aussie dollar.

Actually, just to complicate it a bit further, when economists talk of the real exchange rate, they're usually referring to the real "effective" exchange rate. This is our exchange rate, not against the US dollar or any other particular currency, but against all the currencies of our major trading partners, with each partner's currency weighted according to that country's share of our two-way (exports plus imports) trade. In other words, our effective exchange rate is the trade-weighted index.

(Of the 22 currencies in the trade-weighted basket, the Chinese yuan gets a weight of almost 23 per cent, then the yen with 15 per cent, the euro with 10 per cent, the US dollar on 9 per cent, South Korean won on 6 per cent, India rupee on 5 per cent and so on.)

Whether they talk about the nominal exchange rate or the real exchange rate, economists always think in terms of the real exchange rate because they believe it's always real (inflation-adjusted) variables that matter.

It's the real growth in gross domestic product that's important, and real interest rates and real wage rates that influence people's behaviour. (When people pay too much attention to nominal variables, they're said to be suffering from "money illusion".)

Let's assume the nominal effective exchange rate stays stable for a period. If our inflation rate is higher than the average inflation rate of our trading partners, the real exchange rate is appreciating.

If our inflation rate is lower than the average for our trading partners the real exchange rate is depreciating.

Why? Because they are the adjustments necessary to ensure the prices of internationally traded goods and services end up being the same in all countries, as predicted by the theory of "purchasing power parity" (PPP) - economists' main theory about what determines the way exchange rates move.

When economists say a particular currency is overvalued by X per cent, or undervalued by Y per cent, it's the assumption of PPP they're using as the basis for their calculation. But the fact that economists are always making such calculations is a reminder that the actual market exchange rate of a currency can go for years being significantly at variance with where the PPP theory says it should be.

So if PPP holds in the real world, it can only be said to hold over the long term. In the shorter term, lots of other factors affect the way exchange rates move.

However, if we stick to the theory and assume there's an inexorable, "equilibrating" force (a force that moves everything towards equilibrium, or balance) moving every currency towards PPP, then countries that don't allow their currencies to float freely - by, for instance, fixing their currency to that of another country - will find their inflation rate adjusting to move their real exchange rate in required direction.

Thus if you're holding your currency's value too low (according to PPP), you'll end up with an inflation rate that's a lot higher than your trading partners' rates, which will cause your real exchange rate to appreciate. Many economists would say this is China's problem at the moment.

All this is great fun if you like fancy analysis (as economists do), but does it matter? It matters to the economy - and to a lot of business people - because our real effective exchange rate is the best measure of the "international competitiveness" of our export and import-competing industries.

And thanks to the huge appreciation in the nominal exchange rate brought about by the foreign exchange market's response to the sky-high prices we're getting for our coal and iron ore, our real effective exchange rate is the highest it's been since the mid-1970s and about 40 per cent higher than its average since the dollar was floated in 1983. In other words, it's a long time since our tradeables industries were less competitive internationally than they are today. This isn't a great problem for our miners, because the world prices they're getting are so high at present, nor is it a great problem for our farmers, whose prices for many items are high, too.

But it is a big problem for our manufacturers and the producers of our two biggest services exports: tourism and education. Actually, both manufacturing and tourism are import-competing industries as well as export industries. They're getting wacked.

Remember this, however: because economists are so obsessed by prices, they often forget to make it clear they're talking about international price competitiveness. When you're exporting undifferentiated, bulk commodities - whether mineral or agricultural - price competition is the main game.

But for more sophisticated products, there's plenty of non-price competition. You can compete on quality, stylishness, reputation, reliability, service and so forth. You can cater to niche markets the big boys don't bother with. Such "business models" can allow you to have higher prices and still make sales.

Since there's nothing sensible the authorities can do to lower our exchange rate - real or nominal - and since it looks likely to stay high for many moons, the more our hard-pressed tradeables industries focus on non-price competition, the better they'll survive.

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Primary products are setting us up well

For many years - most of the second half of the 20th century - it looked like Australia was on the wrong tram. In a world of ever-more high-tech, sophisticated manufactured goods, we were hewers of wood and drawers of water. To put it less biblically, we paid for our imports mainly by growing things in the ground or digging stuff out of the ground.

We were stalled in primary industry while the rest of the developed world had moved up the ladder to secondary or even tertiary industry. They were doing a lot more ''value-adding'' than we were. The prices we were getting for our agricultural and mineral exports were steadily declining, whereas the prices we were paying for all the manufactures we imported were rising inexorably.

At the time of the Sydney Olympics, when the dollar was heading down towards US 50 cents, visiting business leaders berated us for being an ''old economy'' with few IT start-up companies. That was when it started turning around. The old-economy talk evaporated within a few months with the arrival of the sharemarket Tech Wreck. And not long after, the prices we were receiving for our coal and iron ore took off, lifting the value of our dollar in the process.

Over the past 11 years, the prices we're getting for our exports are up by 7 per cent, whereas the prices we're paying for our imports are down by 9 per cent. Why? The governor of the Reserve Bank, Glenn Stevens, explained it in a speech last week.

''Hundreds of millions of people in the emerging world have seen growth in their incomes and associated changes in their living standards, and they want to live much more like we have been living for decades. This means they are moving towards a more energy- and steel-intensive way of life and a more protein-rich diet,'' he said. ''That fact is fundamentally changing the shape of the world economy.''

We're witnessing a ''large and persistent change in global relative prices''. The world is paying a lot more for the commodities we export - energy, the main ingredients of steel, and food - relative to the prices of everything else, but is also charging a bit less for the manufactures we import.

So whereas it looked for so long that we were backing losers, now it's clear we're in the winners' circle. And we look likely to stay there for many moons. We've had plenty of commodity booms in the past, of course. Prices shoot up, then crash back to earth. And no one imagines the prices we're getting for coal and iron ore will stay at their present stratospheric levels for long.

Even so, this boom seems likely to last a lot longer - say, a decade or more - than previous booms. Indeed, it has already lasted a lot longer than we're used to. Past booms have been based on a cyclical (and thus temporary) upswing in the developed world's demand for our commodity exports, whereas this one is based on a structural (and thus longer-lasting) change in the world economy: the rapid industrialisation and urbanisation of the two most populous economies, China and India, with various other developing countries following in their wake.

Only the natural environment's inability to cope is likely to halt this development. So it will survive the temporary speeding-ups and slowing-downs of the Chinese and Indian economies. And though coal and iron ore prices are bound to fall, they're unlikely to fall back all the way. They should remain a lot higher than they were throughout most of the past century. If so, our dollar is likely to stay high rather than revert to its average level of about US70? since it was floated in 1983.

Another thing that makes this time different is the huge surge of investment in new mines and natural gas facilities. This is likely to run for a decade or more, and will be the main factor driving the economy's growth. It's the main reason the Reserve Bank keeps warning that interest rates will need to rise, even though consumer spending isn't all that strong.

But it's not just our miners who are doing well. The rapidly rising wealth of developing Asia is increasing its demand for more protein-rich food. That increased demand is raising the price of food. We've already heard a lot - and will hear a lot more - about rising world food prices. This is invariably presented as a terrible thing - a ''crisis'' - and to many people it is. But it's not a bad thing that the people of Asia can now afford to eat better. And it certainly ain't a bad thing for our farmers. Now you know why, for once, farmers aren't whingeing about the high dollar. Again, only environmental problems will inhibit their ability to clean up.

Consumers throughout the developed world are experiencing a rise in the prices of food, energy and raw material-intensive manufactures, which lowers their standard of living. That includes Australian consumers, though we enjoy the spill-over benefits of living in an economy that's a major global supplier of raw materials.

In economics, however, there are no benefits without costs (leading to a net gain in this case, or a net loss in others). The world having seriously changed its mind about the value of the raw materials we supply to it, we must now rejig our economy to fit.

We're getting a very much bigger mining sector and a revitalised agricultural sector, but we can't be good at everything and so the manufacturing sector's share of the economy will shrink. For us, it's back to the future.

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Mouse is mightier than the stores

Well-mannered newspapers don't spend a lot of time talking about themselves. Even so, you've no doubt heard that the future of newspapers - though not news or journalism - is under great challenge from the arrival of the internet.

Much classified advertising has moved to the net and now some display advertising is going.

Some readers are moving to the net, smartphones and tablets such as the iPad.

As you may imagine, these are anxious times for newspaper managers and print journalists.

It's dawned on me, however, that what the internet is doing to the media is just for openers.

You wait until you see what it does to retailing over the next decade or two.

Retailers have been complaining lately about people buying more stuff on the internet - and thus being able to avoid paying goods and services tax on purchases of less than $1000 - but I doubt if this does much to explain their present weak sales.

A report by Southern Cross Equities shows that by last year local online retailers had a 4 per cent share of total retail sales.

This was up from 2 per cent in 2005, but it's still not a lot.

Yet come back in 10 years and it may be a very different story.

Buying things in shops has many advantages. You're able to see, touch and even try on what there is to choose from. You can seek further information from a live human. There's less worry about the security of your payment and being able to return goods that prove unsatisfactory.

So why would people buy online? Partly because, if you know what you want, it's very convenient. You avoid having to find a park at crowded shopping malls and avoid unwanted human contact.

But a new study by Ben Irvine and colleagues at the Australia Institute, The Rise and Rise of Online Retail, finds that online shoppers give ''saving money'' as their primary reason. ''Bargain hunters'' outnumber ''mall haters'' five to one.

When bricks-and-mortar retailers also run a website they tend to charge the same prices on both. If they didn't, more of their customers would switch to online. Add the cost of postage (and ignore the cost in time and money of travelling to their shop) and it's often not particularly attractive to buy from local retailers online unless you find one offering a much lower price.

It's when people browsing prices on the internet compare prices being offered on overseas sites that they find large savings, sometimes up to 50 per cent - savings that make the freight costs well worth paying. This is true for books, DVDs, music, shoes, electronic goods and much else.

People are amazed to find that global corporations are selling the identical goods at quite different prices in different countries.

As a very broad generalisation, prices tend to be low in the United States and high in Australia, with British prices somewhere in between.

Our retailers and others try to justify these differences by reference to freight costs, differences in taxes, the high Aussie dollar and much else, but they never can.

Many people imagine prices are based on the cost of manufacture and distribution, plus a reasonable mark-up. But, in economists' speak, this is just looking at the supply curve.

You also have to take account of the demand curve, which shows the prices customers are
''willing to pay''.

Taking this into account means prices are set at the highest level ''the market will bear''. Charging different prices in different markets (whether those markets are in different countries or are different segments of the same country's market) is a long-standing business strategy.

You maximise your profit by charging whatever price - high or low - is the most the people in each market or market segment are willing to pay.

Economists call this ''price discrimination'' and regard it as perfectly reasonable.

Now here's something the economists won't tell you: people are willing to pay higher prices in Australia because that's what they're used to. People are willing only to pay lower prices in the US because that's what they're used to.

As every economics textbook will tell you, however, the trick to successful price discrimination is you have to be able to keep the markets separate, otherwise people in high-price markets will switch to buying in lower-price markets.

Guess what? The internet has broken down the geographic (and knowledge) separation between national markets. So the game is up for country-based price discrimination. It will take a while but, as e-commerce spreads, our greater ability and willingness to buy from countries with lower prices will force Australian retail prices down, particularly website prices. (The day may come when people who want personal service in a shop will have to pay a premium above the internet price.)

This will be an enormously painful process for retailers and their employees (welcome to the club). And also for the firms that own and rent out retail space.

It will be painful because it's wrong to imagine Australian retailers charging twice as much for the identical product as US retailers charge are therefore making twice the profit.

Why not? Because, over the many decades this price difference has existed, Australian retailers' cost structures have adjusted to fit (just as broadsheet newspapers' staffing levels increased to absorb most of the ''rivers of gold'' flowing from their classified ads). In particular, the rent paid by retailers would be much higher.

The internet is changing the world to make it work more like economics textbooks have always assumed it worked.

It's intensifying price competition over other forms of competition, such as marketing, and slowly bringing to reality a concept beloved of economists: ''the law of one [worldwide] price''.

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