Time for new thinking on reforms to encourage growth

Disheartening times are times for fresh thinking. The voters' effective rejection of conventional economic solutions at the election require our economists and policy makers to go back to the drawing board.

It's always tempting to blame the salesman for his failure to make a sale but, of late, that argument is wearing thin. It's more useful to ask whether sales would be more forthcoming if we improved the product.

Everyone accepts the importance of innovation and agile thinking but, as with most professions, it doesn't come easy to economic practitioners.

They need to go back over their thinking, looking for factors they may have missed or conclusions that aren't as solid as they've long assumed.

One simplifying assumption economists have long relied on is that "equity" and "efficiency" are in conflict. The things you could do make the economy fairer come at the cost of reducing incentives and causing the economy to grow more slowly.

Conversely, the things you could do to improve incentives and growth will, regrettably, make the economy less fair.

On this, however, the tide of international opinion is turning. Several studies by economists at the International Monetary Fund and the Organisation of Economic Co-operation and Development find that increased inequality of income leads to slower economic growth.

If this advance in understanding of ways to encourage growth has filtered through to "the government's chief economic advisers" in Treasury, we've yet to see any sign of it.

But the message hasn't been lost on the Labor Party's think tank, the Chifley Research Centre. In a paper prepared for the centre, Equity Economics, a consultancy, explains the two mechanisms by which inequality can dampen economic growth.

First, the more of the growth in income that's captured by high income earners, the less income that flows back into consumption.

This is because high-income households tend to save a much higher proportion of their income than do middle and particularly low-income households.

It's clear this is a big problem in the United States, where a quite amazing proportion of income growth is being captured by the top few percent of households.

It would be a significant factor in helping to explain America's low rate of growth in recent decades.

It's not such a big factor in Australia yet, but it will be if we let our top few percent continue increasing their share at the rate they have been.

The second mechanism by which inequality dampens economic growth is longer term. Lower growth in the incomes of families towards the bottom of the distribution limits their ability improve their knowledge and skills by investing in their own education.

The same applies when governments shifting more of the cost of healthcare on to out-of-pocket payments discourage workers from doing all they should to protect their health.

The Gini coefficient measures income inequality on a worsening scale from 0 to 1. Modelling by the OECD has found that a reduction of 1 percentage point in the coefficient will cause the level real gross domestic product in 25 years' time to be up to 5.7 per cent higher than otherwise.

To err on the conservative side, Equity Economics caps the increase at 3 per cent, before comparing it with modelling exercises showing that the national competition policy reforms of the 1990s raised the level of GDP by 2.5 per cent, and that the combined preferential trade agreements with Japan, South Korea and China will raise the level of GDP by just 0.1 per cent over the long term.

Now, I never take such modelling results too seriously. They rest on too many unstated and debatable assumptions. But the comparison does suggest there's a lot to be gained by taking steps to halt the continuing widening of the gap between high and low income-earners.

So what sort of reforms could be made to improve growth in this way?

Of the paper's five suggestions, the top two are, first, improve access to quality education to increase economic and social mobility, starting with early childhood education, right through to needs-based student funding and affordable higher education.

Second, improving labour outcomes for women, through flexibility in childcare options, paid parental leave and reducing the gender pay gap so that returning to work is financially viable.

Clearly, such reforms are very different from those that economists have been pursuing – with so little acceptance by voters.

Although their cost could be covered by equity-enhancing tax reforms – affecting negative gearing, the capital gains tax discount, superannuation and the taxation of multinational companies – they require policy makers to be more agile in their thinking than they've been to date.

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Big change ahead for China and our export challenge

You don't need me to tell you we lucked out when we sited our island continent not too far from China. But will our luck hold?

Or, more pointedly, what do we have to do to ensure we stay lucky?

A major report, released this week, Partnership for Change, seeks to answer that question. It was prepared jointly by Professor Peter Drysdale, of the East Asian Bureau of Economic Research at the Australian National University, and Zhang Xiaoqiang, of the China Centre for International Economic Exchanges, with strong support from both governments.

Actually, our location on the edge of Asia is only half our good luck. The other half was discovering our island is rich in high quality, easily-won minerals and energy.

As a result, our economy has proved a fabulous fit with the re-emerging China. As the report explains, "Australia and China are deeply complementary trading partners".

Our "comparative advantage" is opposite to China's. A country has a comparative advantage in producing a particular item if it can do so at lower opportunity cost than other countries face.

"Australia has a large natural resource base relative to its population [so it] therefore specialises in the production of primary goods for export, and uses the proceeds to purchase labour-intensive and other manufactured goods," the report says.

"Conversely, China has a large labour supply, but relative to its population has smaller endowments of natural resources and accumulated capital. For this reason, China's industrial development was built on labour-intensive production, which it exchanges with Australia for imports of scarce resources."

And what a successful partnership it's been. In the space of not much more than a decade, China has become our biggest trading partner. It takes about 35 per cent of our exports of goods and services, and supplies almost 20 per cent of our imports of goods and services.

China is so big - its population is 56 times ours - and has been so successful in pursuing this growth strategy it's now the second biggest economy in the world (the biggest, if you allow for differences in purchasing power), the biggest trading nation and the world's biggest producer of manufactured goods.

But nothing stays the same. The resources boom that saw our trade with China grow so dramatically has reached its final stage. Prices for coal and iron ore have now fallen back.

The period of massive investment in new mines and natural gas facilities is ending, with construction spending falling sharply. The last stage is big growth in the quantity of our mining exports, with large increases in natural gas exports (mainly to China) still to come.

The boom was ended by big increases in the supply of commodities (from our competitors as well as us), but also by a slowing in China's demand as its need for more steel peaked.

So, after a period of huge expansion in our mining sector, our economy is making the adjustment back to normal, where most growth in production and employment comes from the ever-expanding services sector.

This is happening, with a few bumps. But, as part of its progress to full economic development, China is going through a much more dramatic "transition".

The report says China is "shifting its growth drivers from investment, exports and heavy industry to consumption, innovation and services".

"Chinese production is shifting from a model based on adaptation and imitation of goods, services and technologies developed elsewhere, to a model based on domestic innovation", it continues.

Part of this involves a shift from labour-intensive, low-tech, low-value manufacturing to more advanced, high-tech, high-value manufacturing.

This has already started.  Over the 20 years to 2015, low-tech manufacturing's share of China's total exports of goods has shrunk from almost half to less than 30 per cent.

So the big question is whether, now China is changing direction, it will still be the gold mine it's been for us so far.

China will still need to import a lot of our natural resources, even if its demand for those resources won't be growing as fast.

The report notes that, with prices so far down, our share of China's import market has increased markedly. Huh? It's because, compared with our competitors (including local Chinese mines), we're such an efficient, low-cost producer.

The report has modelled three scenarios for our trade with China over the next 10 years. Drysdale stresses the results aren't exact, but give us an idea.

The "baseline" scenario, where existing trends continue without much change, would see our exports to China grow by 72 per cent, while China's exports to us grew by 41 per cent. (All these figures are in real terms.)

The pessimistic scenario sees China's annual growth falling below 5 per cent during the decade. Even so, our exports to China would grow by 28 per cent, while their exports to us grew by 20 per cent.

The optimistic scenario, however, would see our exports to China grow by 120 per cent, while their exports to us grew by 44 per cent.

And the catch? Both countries would need to engage in supply-side (production) reforms to make it happen.

For China, this would involve reforming its banks and financial system, reforming its state-owned enterprises, and liberalising the capital account of its balance of payments by lifting restrictions on money flows and allowing a freer-floating exchange rate.

For us, it would involve increasing competition in sheltered industries, openness to foreign investment and skills, and facilitating investment in social and physical infrastructure.

These are what we'd have to do to make real our dream of getting our share of all the extra demand for fancy food and services coming from China's by-then massive middle class.

Here we'd be battling against a different and much bigger range of competitors than we face in the commodities market. You wonder if our spoilt business people are up to it.

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