Lifting Productivity: Considering the Bigger Picture

Systemic Weaknesses in Emerging Economies' Financial Systems

The problem with heavy reliance on resource exports is that devoting a high rate of savings to unproductive capital investment is unlikely to be sustainable - and China is like Japan in that it lacks financial systems that are attuned to the profitable use of capital (eg see Understanding East Asia's Economic Models). Accumulating foreign exchange reserves reflects an economies' cash flow, not its balance sheet (ie whether or not savings have been used productively).

Moreover many other emerging economies are in a similar predicament. It was, after all, fear of financial crises associated with the unproductive use of capital (and IMF encouragement) that caused many emerging economies to copy the example set by Japan and China in shifting to export driven economic strategies (and so avoid current account deficits) in the years following the 1997 Asian Financial Crisis.(see Leadership by Emerging Economies). It seems that many investors are assuming that productive investment in emerging economies is now assured - noting the more advantageous terms on which such economies can now obtain sovereign capital (see Economist, 'Asia's Sovreign debt drought', Australian Financial Review, 27-28/2/10). However such investors may well be disappointed.

In the case of economies such as Japan and China, 'demand deficits' (associated with a savings rate that exceeded even the high rates of investment that were being made) have been and remain vital to avoid the need to attract external capital to financial institutions that have made capital available to state-connected entities focussed (as best) on maximizing market share and cash flow, rather than on profitability.

Past Consequences

This has given rise to international financial imbalances that contributed to the global financial crisis (GFC). Those imbalances have been reflected in current account deficits in many developed economies (especially the US) and in corresponding surpluses in Japan, Germany and various emerging economies (most notably China).

Imbalances emerged because maintaining global growth in the face of structural 'demand deficits' (ie excess savings) in East Asia required huge excess demand elsewhere. For many years increases in the value of asset (eg shares / property) driven by easy monetary policy and easy access to credit enabled others (mainly US consumers) to afford the excess demand needed to sustain rapid export-led economic growth. Unfortunately the long term effect of this was the GFC - see Impacting the Global Economy. It can be noted that the important, though not-immediately-obvious, role that international financial imbalances have played in the GFC have been pointed out by various credible analysts (eg the excellent work by Martin Wolf at the Financial Times, such as his book Fixing Global Finance).

Future Consequences

The fundamental constraint on the 'bigger, longer and better' resource boom hypothesis, is that global growth won't be sustainable until the financial imbalance problem is overcome (eg see Martin Wolf's Inevitable Sovereign Defaults). The latter draws attention to the private sector de-leveraging that now characterises developed economies and the limits to government spending that have been reached. Radical economic transformations will thus be required in developed economies (especially the US) - and major consequences may well be: (a) a need by currently-deficit economies to shift to export-based economic growth; and (b) probable financial crises that disable growth in countries (such as Japan and China) that have to rely on current account surpluses to protect financial institutions that lack a real profit focus.

Strategic Directions

Thus economic strategies oriented towards development of the flexibility and productivity of Australia's economy generally and the effectiveness of its governing institutions would be preferred at this time to those geared mainly to assumptions of a 'bigger, stronger and longer' resources boom.

How such a balanced strategy might be given practical effect is suggested in Lifting Productivity: Considering the Bigger Picture. This would neither preclude the growth of resource-oriented industries (if the 'wheels don't fall off' China's economic wagon), nor create undue dependence on their success.

Introduction + Beyond Market Liberalization Beyond Population Ageing Philosophical Principles Addendum: Resource Boom Alternative	Introduction In January 2010 there seemed to be a significant difference of opinion between the Federal Government and the Productivity Commission in relation to the widely-supported goal of raising Australia's economic productivity. Outline of relevant article: The Rudd Government faces pressure to cut industry assistance and lift regulatory burdens to achieve its 2% pa productivity growth target. Productivity Commission (PC) has argued that recent declines in productivity would not be due to infrastructure spending, education and training or R&D. Prime Minister had suggested that productivity gains would be achieved by infrastructure investment, doubling schools investment and investing in business innovation (including manufacturing and the National Broadband Network). The Opposition claims the Government had squandered its budget surplus, while government suggested that Howard Government wasted mining boom by raising spending by 3.8% pa. PC argues that the keys to raising productivity are: improving incentives to competition; and removing barriers (eg regulation). Raising productivity depends on the activities of individual firms - and the competitive pressure that results in better-performing firms and industries prevailing over others. The government's $17.5bn spending on industry assistance (eg farm subsidies, R&D funding and industry protection) has not been reviewed. The PC also identifies a need to test substantial possible increased industry assistance connected with greenhouse policy response to ensure that it does not detract from productivity growth (Uren D., 'Pressure mounts on PM Kevin Rudd's productivity target', The Australian, 20/1/10). This document will suggest that: while the Productivity Commission is correct in relation to the inadequacy of the Rudd Government's 'productivity' initiatives, the Commission's alternative solution (reducing dysfunctional government incentives / obstacles facing individual enterprises) is too narrow. These are not the only institutional rigidities affecting the economy that need liberalization; there is a need to boost Australia's productivity for reasons other than coping with an ageing population (eg to reduce dependence on uncertain capital inflows; ensure an ability to cope with a potentially difficult international environment; and inhibit the emergence of social and political instability in disadvantaged regions); there may be important philosophical issues at stake in this debate that require much closer attention. In March 2010, it was suggested that, as Australia was likely to experience a resources boom that was 'bigger, longer and better than most people imagine', so focusing attention of productivity was not really necessary. An outline of, and comments on, that viewpoint are included as an addendum to this document.
Beyond Market Liberalization Accelerating Market-Oriented Development Infrastructure Rigidity Motivating State Governments	Beyond Market Liberalization While the Productivity Commission seems correct in highlighting the impediments to productivity growth through politically driven initiatives such as those Mr Rudd apparently advocates, the Commission's reported view that productivity depends on the activities of individual firms (and the incentive / obstacles that government provides) is too narrow. Liberalization of other other institutions which impact on Australia's economy is also needed (eg empowering civil institutions to accelerate development of market economic systems, and breaking down dysfunctional centralization that affects the public institutions involved in developing infrastructure and encouraging economic development). Accelerating Market-oriented Development of Economic Systems Productivity does not only depend on incentives for competition and the absence of unnecessary government constraints or of interventions to benefit interest groups. The effectiveness (ie level of development) of the entire economic system is important (as illustrated by the literature on industry clusters). The problem with economic reform in Australia over the last two decades (and a likely significant factor in the productivity slowdown over the past decade) is that emphasis has been placed on creating a competitive environment, but not on the systemic requirements for individuals / enterprises to compete successfully in high value-added activities in such an environment (see The Inadequacy of Market Liberalization). For example, innovation is an important method for improving productivity (see Economic Role of Technology), and support for this has been a key aspiration of all governments since the 1980s (eg consider the federal government's 'Backing Australia's Ability' program and similar state efforts). There has for years been widespread recognition by policy analysts of the importance of effective innovation systems (ie complementary support for innovating firms from other entities that contribute research, intellectual property law, appropriate financing, management, marketing, logistics etc). However despite this, innovation systems are not well developed, and in fact have been getting worse - perhaps because of the misguided way governments tried to support them (eg see Political 'Push' on Economic Inputs can Achieve Little). The problem is that boosting 'smart' inputs (eg research, education, training) into economic systems that are not well enough developed to use them productively is not helpful. Rather it is necessary to start by boosting the effectiveness of innovation systems as a whole (which is possible through a market-oriented process to accelerate 'learning' within the real-world embryonic innovation system) so as to increase the economy's ability to productively use, and its demand for, those 'smart' inputs. How this might be achieved in practice, through apolitical institutions, is speculated in A Case for Innovative Economic Leadership. The latter described the need for a sustained community / business based leadership process - rather than a quick fix through government fiscal or regulatory actions, though democratic endorsement of the protocols through which diverse civil institutions could take such a leadership role would seem highly desirable. Leadership can not be undertaken politically, because changes will only contribute to productivity if they are initiated early - before they become obvious to 'everyone' and thus politically acceptable. In the absence of such a process to stimulate changes within economic systems as a whole, such development faces a 'chicken and egg' constraint (ie such systemic capabilities are only viable when a large number of firms want to use them, and no individual firm can succeed and start to create that demand until the system as a whole already exists). While this constraint is most severe in regions that are plainly 'under-developed', the fact is that changing market and technological requirements ensure that all regions are likely to benefit from faster adjustment. Rigidity in Institutions Developing Infrastructure The timely and efficient provision of infrastructure (eg transport, urban utilities) is important to the effectiveness of the economy, and yet major limitation in Australia's institutional capacity to deal with this have developed. This issue is considered separately in Infrastructure Constraints on Australia's Economy, which referred to diverse defects such as; fiscal imbalances in Australia's federal system; fragmentation of responsibility; politicisation of public administration; attempts at centralised planning; and increased complexity due to private controls over functions subject to market failures. Motivating State Governments Governments also have an impact on whether a productive modern economy develops - noting the 'development' programs of various sorts that are undertaken). Unfortunately because the Grants Commission equalizes funding on the basis of 'needs' and only a narrow tax base is available to state administrations (which have the leading governmental role in affecting the character of economic development in Australia), the latter do not have an incentive to take this responsibility seriously, and the financial interests of state governments diverge from the economic interests of the community generally. (see Providing Incentives for Effective Economic Development). A broader own-tax base for state governments (ie one linked more to value-added than to economic turnover) seems vital if more productive economic activities are to be officially encouraged (eg see comments on one state's history of adopting ineffective economic development tactics in Queensland's Economic Strategy).
Beyond Population Ageing	More is at Stake than Meeting the Costs of an Ageing Population The Prime Minister has reportedly explained the need for faster productivity improvement in terms of meeting the increased budgetary costs of an ageing population. This point has undoubted validity. However there are other issues at stake. Firstly, Australia is highly dependent on foreign capital inflow, and there was some risk as a result of the global financial crisis that this might have been disrupted. Thus government guarantees of bank deposits were arguably vital at one stage to prevent the spread of a global 'credit crunch' to Australia with disastrous consequences, There is thus a need to increase Australia's savings to reduce dependence on capital inflow, according to Westpac CEO, Gail Kelly (see Cut Government taxes on savings, says Westpac boss Gail Kelly', 4/11/09). Increasing incomes (through lifting productivity) whilst constraining the availability of consumer credit would be likely to increase Australia's savings rate and reduce dependence in future on uncertain capital inflows. Secondly, the global financial crisis may not yet be 'history' (eg see Unresolved Problems and Coming Crises?). Thus it is not realistic to assume that the economic challenge is simply to deal with a new (say China-driven) boom. Rather it is vital to maintain the sort of flexibility and vigour in the economy that will contribute to rising productivity, in order to also best be able to cope (if necessary) with an unstable / unpredictable international economic environment. Thirdly, boosting the productive capabilities of regional economies through a systemic development process is vital to ensure that none are left behind - as socially and politically disruptive outcomes (such as the One Nation phenomenon in the 1990s) may otherwise emerge (see *Assessing the Implications of Pauline Hanson's One Nation*)
Principles	Philosophical Principles There are probably important philosophical principle at stake. The Prime Minister seems to be implying that major initiatives that will boost productivity can best be determined by 'social democrats', rather than through the market. This is implicit in his reported references to (say) infrastructure; education spending and direct government support for particular innovations as the foundation for lifting productivity. Mr Rudd's perspective on this are presumably based on his suggestions that "neo-liberalism" was to blame for the global financial crisis, so that 'social democrats' now need to save capitalism from itself (see A Social Democratic Alternative to 'Neo-Liberalism'?). Unfortunately, as the latter suggested, Mr Rudd's assessment of the issues involved seemed somewhat simplistic. It would thus be an unwise starting point for defining Australia's future economic strategies. The alternative suggested above is based on what the present writer suspects is a philosophically and practically significant breakthrough in understanding economic development (and the way in which information contributes to economic growth).
Addendum	Addendum: The 'Bigger, Longer and Better' Resource Boom Hypothesis In early 2010 many observers noted the potential for a resources boom as a consequence of the rapid growth arising in China and other emerging economies in the wake of (at least the first phase of) the global financial crisis. However there has been a well-established view since the 1980s that Australia needs to diversify it economy away from reliance on commodity exports because of their boom-bust character, and because resources booms tend to hollow-out other industries (eg by raising exchange rates and thus undermining other sectors' competitiveness) - a phenomenon which has been labelled the Dutch Disease. In relation to such concerns it was argued that the emerging resources boom (from which Australia's economy could benefit enormously) would be strong and durable, and that productivity down-turns associated with periods of high investment do not last. The debate about effect of resources boom on economy has taken an unduly negative tone (ie considering stress on other sectors). Key component of growth are: investment; labour force growth; and productivity. Emerging markets (eg China and India) will grow faster than the developed economies because of: (a) faster working age population growth; (b) higher rates of savings and investment. Emerging markets have driven the rapid growth in capital accumulation over the past decade, and Australia is helping the development of infrastructure through commodity exports. China and India are well short of the $15000 / capital income levels at which growth slowed in Japan and Korea. Energy is likely to be focus of next phase of Asian demand. However resources sector is just entry point. Higher commodity prices has multiplier effect on economy generally by lifting demand. Productivity growth usually slides during investment booms - but has recovered in the past. Rapid Asian growth and rising demand for raw materials will continue and significantly boost Australia's economy. (Rider M., (UBS Global Asset Management), 'The boom will be bigger, longer and better than most imagine', The Australian, 1/3/10 ) This view does not, unfortunately, take account of structural features that could easily lead to financial crises in emerging economies (especially China) on whose growth the resources boom depends. Thus, for reasons outlined below, it seems that corporate and economic strategies in Australia should be based on the development of the economy and governing institutions generally - rather than giving special emphasis to resource exports. Systemic Weaknesses in Emerging Economies' Financial Systems The problem with heavy reliance on resource exports is that devoting a high rate of savings to unproductive capital investment is unlikely to be sustainable - and China is like Japan in that it lacks financial systems that are attuned to the profitable use of capital (eg see Understanding East Asia's Economic Models). Accumulating foreign exchange reserves reflects an economies' cash flow, not its balance sheet (ie whether or not savings have been used productively). Moreover many other emerging economies are in a similar predicament. It was, after all, fear of financial crises associated with the unproductive use of capital (and IMF encouragement) that caused many emerging economies to copy the example set by Japan and China in shifting to export driven economic strategies (and so avoid current account deficits) in the years following the 1997 Asian Financial Crisis.(see Leadership by Emerging Economies). It seems that many investors are assuming that productive investment in emerging economies is now assured - noting the more advantageous terms on which such economies can now obtain sovereign capital (see Economist, 'Asia's Sovreign debt drought', Australian Financial Review, 27-28/2/10). However such investors may well be disappointed. In the case of economies such as Japan and China, 'demand deficits' (associated with a savings rate that exceeded even the high rates of investment that were being made) have been and remain vital to avoid the need to attract external capital to financial institutions that have made capital available to state-connected entities focussed (as best) on maximizing market share and cash flow, rather than on profitability. Past Consequences This has given rise to international financial imbalances that contributed to the global financial crisis (GFC). Those imbalances have been reflected in current account deficits in many developed economies (especially the US) and in corresponding surpluses in Japan, Germany and various emerging economies (most notably China). Imbalances emerged because maintaining global growth in the face of structural 'demand deficits' (ie excess savings) in East Asia required huge excess demand elsewhere. For many years increases in the value of asset (eg shares / property) driven by easy monetary policy and easy access to credit enabled others (mainly US consumers) to afford the excess demand needed to sustain rapid export-led economic growth. Unfortunately the long term effect of this was the GFC - see Impacting the Global Economy. It can be noted that the important, though not-immediately-obvious, role that international financial imbalances have played in the GFC have been pointed out by various credible analysts (eg the excellent work by Martin Wolf at the Financial Times, such as his book Fixing Global Finance). Future Consequences The fundamental constraint on the 'bigger, longer and better' resource boom hypothesis, is that global growth won't be sustainable until the financial imbalance problem is overcome (eg see Martin Wolf's Inevitable Sovereign Defaults). The latter draws attention to the private sector de-leveraging that now characterises developed economies and the limits to government spending that have been reached. Radical economic transformations will thus be required in developed economies (especially the US) - and major consequences may well be: (a) a need by currently-deficit economies to shift to export-based economic growth; and (b) probable financial crises that disable growth in countries (such as Japan and China) that have to rely on current account surpluses to protect financial institutions that lack a real profit focus. Strategic Directions Thus economic strategies oriented towards development of the flexibility and productivity of Australia's economy generally and the effectiveness of its governing institutions would be preferred at this time to those geared mainly to assumptions of a 'bigger, stronger and longer' resources boom. How such a balanced strategy might be given practical effect is suggested in Lifting Productivity: Considering the Bigger Picture. This would neither preclude the growth of resource-oriented industries (if the 'wheels don't fall off' China's economic wagon), nor create undue dependence on their success.