Gittins' Guide to Economics

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GITTINS’ GUIDE TO ECONOMICS

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GITTINS’ GUIDE TO ECONOMICS

ROSS GITTINS

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First published in 2006 Copyright © Ross Gittins 2006 All rights reserved. No part of this book may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording or by any information storage and retrieval system, without prior permission in writing from the publisher. The Australian Copyright Act 1968 (the Act) allows a maximum of one chapter or 10 per cent of this book, whichever is the greater, to be photocopied by any educational institution for its educational purposes provided that the educational institution (or body that administers it) has given a remuneration notice to Copyright Agency Limited (CAL) under the Act. Allen & Unwin 83 Alexander Street Crows Nest NSW 2065 Australia Phone: (61 2) 8425 0100 Fax: (61 2) 9906 2218 Email: [email protected] Web: www.allenandunwin.com National Library of Australia Cataloguing-in-Publication entry: Gittins, Ross. Gittins’ guide to economics. Includes index. ISBN 1 74114 799 9. 1. Economics. I. Title. 330 Set in 11 on 14 pt Adobe Garamond by Midland Typesetters, Australia Printed by McPherson’s Printing Group 10 9 8 7 6 5 4 3 2 1

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CONTENTS

Preface Abbreviations Part I Introduction to economics

1 2 3 4

Money isn’t what it’s all about How the economy works It all gets down to scarcity Economists’ obsession with prices

Part II The labour market

5 6 7

How the labour market works Reform of the labour market The labour market’s changing future

vii viii 1

3 7 12 15 19

21 25 31

Part III The financial markets

35

8 9 10 11

37 41 46 50

How interest rates affect demand and inflation How the Reserve Bank influences interest rates Real interest rates and expected inflation The dollar goes up as well as down

Part IV Government and the economy

57

12

59

Market failure and government failure

Part V The global economy

65

13 14

67 72

How globalisation is helping poor countries The pros and cons of financial globalisation

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15 16 17

The World Trade Organisation’s Doha round Transnational corporations’ size is exaggerated The rise of China

Part VI Australia’s place in the global economy

18 19 20 21

Composition and direction of our exports Australia’s growing investment abroad Why industry protection doesn’t work How globalisation affects our economy

77 82 86 91

93 97 101 105

Part VII Economic issues

113

22 23 24 25 26 27

115 119 126 131 136 140

The coming slowdown in economic growth Good news and bad on unemployment How we tamed inflation Why we worry less about the current account deficit The distribution of income Management of the environment

Part VIII Economic policies and management

145

28 29 30 31 32 33

147 152 157 161 165 169

Index

Shocks to the economy Macro management and the business cycle The changed policy mix Fiscal policy versus monetary policy A different perspective on monetary policy Microeconomic reform and productivity improvement

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PREFACE

This book is intended for students of economics of all ages, but particularly those at senior secondary and tertiary levels. It’s not a textbook, however. Rather, its role is complementary, bridging the gap between theoretical and rapidly dating texts, and the everchanging world of economics as applied to the Australian economy. I trust it’s also more accessible and readable than a text. It could serve as a primer to those whose days of formal education are behind them, but who have discovered a need to get up to speed on matters economic. Versions of most of the chapters in the book have been published previously as articles in The Sydney Morning Herald and The Age, particularly in my column in the business section on Saturdays. A few chapters have been drawn from speeches I’ve given, and some have been specially written for the book. All have been revised and updated to incorporate recent developments and the latest statistics. Thanks to my boss, Robert Whitehead, and to Chris Caton and Tracey McNaughton of BT Financial Group, and especially to Kieran Davies of ABN Amro for help with graphs. Ross Gittins Sydney, August 2005

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ABBREVIATIONS

ABS ASEAN AWA CAD CEO CGS DFAT ERA FDI GATT GDP GNE GST IMF IRC ICT LPG MFP NAIRU OECD OPEC PC PPP RBA TCF TRIPS TWI WTO

Australian Bureau of Statistics Association of South-East Asian Nations Australian Workplace Agreement Current Account Deficit Chief Executive Officer Commonwealth Government Securities Department of Foreign Affairs and Trade Effective Rate of Assistance Foreign Direct Investment General Agreement on Tariffs and Trade Gross Domestic Product Gross National Expenditure Goods and Services Tax International Monetary Fund Industrial Relations Commission Information and Communications Technology Liquid Petroleum Gas Multi-Factor Productivity Non-Accelerating-Inflation Rate of Unemployment Organisation for Economic Co-operation and Development Organisation of Petroleum Exporting Countries Productivity Commission Purchasing Power Parity Reserve Bank of Australia Textiles, Clothing and Footwear Trade-Related Aspects of Intellectual Property Trade-Weighted Index World Trade Organisation viii

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par t I

INTRODUCTION TO ECONOMICS

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chapter 1

MONEY ISN’T WHAT IT’S ALL ABOUT

Joan Robinson, distinguished Cambridge economist and contemporary of Keynes, once said that the purpose of studying economics is to learn how to avoid being deceived by economists. My take on the subject isn’t quite so defamatory; I think we study economics to learn when to use the many synonyms for the word ‘money’. Economics is full of them: income, wealth, assets, liabilities, debts, wages, costs, prices, revenue, savings, investment, and more. I was reminded of this notion by an email query from a reader. ‘Could you explain how the new “wealth” is being created year after year on a national and international level?’ he wrote. ‘How do governments and central banks decide how much money to print to replace existing notes and also to cover newly created goods and services? As I understand it, the amount of money flowing around is growing all the time—and it’s not just because of inflation.’ To the person who’s innocent of the study of economics, economics is ‘all about money’. To the person who’s learnt the least bit of economics, however, money is only a small part of economics, and by no means the most important part. We could run the economy without money, at a pinch—though it does work much better with it than without it. 3

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What we couldn’t do without is resources: land (including minerals in the ground and plantations), physical capital (machinery of all kinds, buildings of all kinds, roads, bridges, and other social and economic infrastructure) and labour of all kinds (ranging from builders’ labourers to CEOs and prime ministers). And these days we have to add to those classical resources the ‘environmental assets’ the early economists weren’t really conscious of: air, water, fish in the sea, flora and fauna, and the ecosystem generally. The point is that ‘the economy’ consists of us taking those resources every day and using them to produce a whole host of goods and services, which we promptly consume. That’s what economics is about: studying the processes involved in humanity’s endless round of production and consumption. So, how is new wealth created year after year? That’s how. Not by governments printing money, but by most of us getting up every morning and combining our labour with materials and capital equipment to produce a bunch of goods and services. We each specialise in the production of a particular type of good or service. We then exchange the stuff we’ve produced for the stuff other people have produced so that we each acquire the particular bundle of goods and services we (and our dependants) wish to consume. We could conduct this process of exchanging goods and services without the use of money—that is, by means of barter— but we find it much more convenient to use an invention called money as a ‘medium of exchange’. See the point? The wealth of a particular society—the United States, say, or South Korea—is determined not by how much money it prints, but by the value of all the goods and services it produces in a period (which is, of course, its ‘gross domestic product’). The thing to understand is that money has no intrinsic value. Its value is derived from its ability to command real resources—that is, from the quantity and quality of goods and services it enables you to buy.

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Consider an economy that produced no more goods and services this year than it did last year, but which doubled the amount of money in circulation. Would that make its citizens twice as wealthy? Hardly. What you’d have is a classic case of inflation—‘too much money chasing too few goods’. You’d expect wages and prices to double and the purchasing power of a dollar to halve, leaving everybody no better or worse off than they were. (In practice it may be more complicated than that, particularly if there’s a lot of idle labour and production capacity at the time, but that’s a topic for another day.) Moral: it’s the amount of production that matters, not the amount of money in circulation. Money’s role is mainly to grease the wheels of production, exchange and consumption. At the level of a particular society, economists use the term ‘wealth’ in two conflicting ways. They’ll say—as I’ve just done— that a nation’s wealth is the value of all the goods and services it produces in a period. Strictly, this is the nation’s ‘income’ and is measured by its GDP. But rather than measuring wealth as the annual flow of income, you can measure it as the value of the stock of physical resources the society owns: its farms, mineral reserves, factories and other businesses, housing, etc.—less the part of those assets owned by foreigners and the debts owed to foreigners. That’s the stricter meaning of the nation’s wealth. And you can do the same thing at the level of the individual worker or household: look at their income over a period or at their net wealth—assets minus liabilities at a point in time. All these amounts we’ll measure in monetary terms, but they won’t be money. Your home, for instance, is a physical asset—it’s not money, though you could turn it into money by selling it. So, regardless of what’s happening to its money, a society increases its ‘wealth’ (its income) by producing more goods and services than it did last year. How? The obvious way is by employing more workers for more hours and by investing in more machines and other physical capital. The less obvious (but far more important) way a

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society increases its production is by improving its technology so as to raise its productivity (its output per unit of input). It does this by inventing better machines and generally finding more efficient ways to combine labour and physical capital. OK. If I’ve convinced you that, despite its obvious usefulness, money isn’t really what the economy’s about, let’s take a closer look at the stuff. The first thing to note is that notes and coins constitute only a fraction of the nation’s money. Money held in bank accounts and the like outnumbers the value of notes and coins by about 20 to one. So how does the central bank decide how many notes to print? That’s easy—it sells the banks all the new notes they want to buy. The amount of currency on issue is, in the jargon, ‘demand determined’. It’s true that the ‘money supply’—being notes and coins plus money in bank and building society accounts—is growing all the time, and by more than just the rate of inflation. But note this: in 2003/04, our economy produced goods and services worth a total of $814 billion. But the amount of ‘broad money’ in circulation that year averaged only $629 billion. So broad money had to turn over 1.3 times to accommodate that year’s production. What does that prove? Nothing much. Money is the shadow, not the substance.

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chapter 2

HOW THE ECONOMY WORKS

There’s nothing like speaking to a talkback jock to get an economist’s feet back on the ground. ‘We can’t get rich buying and selling to each other,’ one of them said to me the other day. I was taken aback. ‘Of course we can!’ I said, a little too abruptly. We can, and we do. ‘Buying and selling to each other’ is exactly the way the great majority of working Australians make their crust. And over the years it’s made us quite rich by the standards of most nations. I’m not quite sure what it is that’s left so many people with the notion that there’s something futile, something unproductive— something incestuous, almost—about buying and selling to each other. I guess it’s the idea that, as a nation, we make our living by selling things to people in other countries—by producing exports, in other words. This is a view that’s strongly held by country people, who see themselves as the people who’re keeping the economy afloat. They produce the bulk of the nation’s export income, and everyone in the cities rides on their backs. It may be our nation’s rural origins that have left many city people seeing things the same way. It is, nonetheless, a mistaken view of the way our economy works. The key to understanding how any economy works is to 7

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remember that, stripped of all the complications, it gets down to two things: production and consumption. To live, we need to consume a host of goods and services. To live well, we want to consume a lot more goods and services than we really need. To buy the goods and services we want, we need income. How do we get that income? By producing goods or services, which we sell to other people. (Most of us, as wage-earners, do this via an employer, but that’s just one of the complications.) If you get the feeling all this seems pretty circular, you’ve got the message: the economy is circular. At bottom, the economy is just a big circle of people busy producing with one hand and consuming with the other. The producing we do generates both the income and the actual goods and services that permit us to consume. The spending and consumption we do creates the need for us to produce some more. It’s a chicken-and-egg relationship, a self-perpetuating cycle. We spend our lives both producing and consuming (though each of us goes through periods at the start and end of our lives when we’re too young or too old to produce and so our consumption has to be paid for by someone else). How rich we are as individuals is determined by our ability to consume goods and services, measured by our incomes and our assets (which are, in a sense, congealed income). How rich we are as a nation is determined by the nation’s annual production of goods and services, gross domestic product(ion), which we usually divide by the size of the population to show average income per person. The point is that this circular process of production and consumption doesn’t necessarily involve any exports. Consider a situation where, for some reason, Australia was cut off from the rest of the world, so we could earn no export income. Does that mean we’d have no economy? Would we all starve? Of course not. We’d still be as busy as we ever were, producing with one hand and consuming with the other. We’d still earn our incomes by producing; we’d still

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HOW THE ECONOMY WORKS

Sold to Australians

What Australians produce

82% Sold to foreigners 18%

Bought from Australians

What Australians spend

80% Bought from foreigners 20%

Figure 2.1

9

Total annual production:

$814bn

Total annual spending:

$836bn

How the economy works

Source: ABS

spend most of our incomes on consumption. We’d be ‘getting rich by buying and selling to each other’. Now, here’s the trick. When you switch from this ridiculous example to the real world, you find it’s not all that much different. In 2003/04, the total value of the goods and services we produced in Australia was $814 billion (Figure 2.1). Of this, the total value of the goods and services we exported was $144 billion. That’s about 18 per cent. So 82 per cent of all the goods and services Australians produce are sold to other Australians. In the same year, the total amount Australians spent on goods and services (known as gross national expenditure) was $836 billion. Of this, total spending on imported goods and services was $167 billion. That’s 20 per cent. So 80 per cent of all the goods and services Australians buy is bought from other Australians.

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See the point? By far the biggest part of our economic activity— about 80 per cent—involves ‘getting rich by buying and selling to each other’. So it’s quite wrong to think of export income as the rock on which the economy is built. In fact, it’s the other way round: exports are an optional extra. In which case, what is the role of exports? Why are they so widely regarded as a ‘good thing’? This will shock you: the only thing that’s good about export income is that it can be used to buy imports. It’s not exports that are good, it’s imports. The ‘goodness’ of exports is derived from imports. Let me ask you a question: do you live to work or do you work to live? The other way to put the question is: do we derive our satisfaction from producing or from consuming? Most people would say that we work to live and we produce only so we can consume. Just so. Now, remember this: we produce exports, but we consume imports. (It’s logically impossible for us to consume our exports or for us to produce our imports.) So exports are merely a means to an end: we produce exports so we can consume imports. Along with the mistaken idea that, as a nation, we make our living by selling things to people in other countries is the equally mistaken notion that the way we get rich is to export as much as we can and import as little as we can. That way we make a profit, so to speak, from our dealings with the rest of the world. But think about it. As a nation, we earn as much foreign exchange as possible from exports, but we spend as little of it as possible on imports. Terrific. What can we do with the foreign exchange we’ve got left over? Nothing—except lend it to foreigners. Apart from that, the nation can use its foreign exchange earnings only to buy imports. (You may think that, right now, lending to foreigners would be a good idea—because it would reduce the huge sum they’ve lent to us. You could be right. My point, however, is that doing this would amount to producing more than we consume—that is, saving. The only way we can consume from our foreign exchange earnings is by spending them on imports.)

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HOW THE ECONOMY WORKS

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So what’s the point of international trade? What’s the point of earning income from exports if all we can do with that income is spend it on imports? The point of international trade is that it extends the benefits of internal trade. We can get rich by buying and selling to each other, but we can get even richer by also buying and selling to people in other countries. Internal trade is based on exploiting the advantages that come from ‘specialisation and exchange’. Each of us specialises in producing a particular good or service, then exchanges it with other Australians who’ve specialised in producing something else. This specialisation makes all of us better off than if we each tried to be self-sufficient. But why should this beneficial process stop when it gets to the border? We extend the process of specialisation and exchange to foreigners because it makes us—and them—better off. But that means we import roughly as much as we export.

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chapter 3

IT ALL GETS DOWN TO SCARCITY

The waiting lists for elective surgery in public hospitals aren’t an unfortunate stuff-up that we’re working to fix, they’re a design feature of Medicare and will be with us for the duration. Some people are shocked when they hear me say that, but to anyone who’s studied a little economics, it’s a statement of the obvious. Indeed, you need only to have absorbed the very first lesson. State politicians always seek to give us the impression that waiting lists—or, more meaningfully, waiting times—are an evil they’re struggling to overcome (especially around election time). And if the government’s incapable of fixing the problem, the opposition’s sure it can do the trick. The doctors’ lobby groups give us the impression that waiting lists could be quickly eliminated if only the pollies weren’t so mingy and would spend just a few million more on our hard-pressed public hospitals. Because many doctors are surprisingly weak on economics (I know from the letters they send me), they seek to explain waiting lists in terms of too few operating theatres or too few of particular kinds of surgeons (just so long as the latter can be portrayed as the product of government tightfistedness, not the college of surgeons seeking to bolster surgeons’ fees by restricting supply). 12

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But while these factors may play a part in the problem, they don’t go to its heart. At its heart it’s an instance of what economists call ‘the economic problem’. As you learn on day one of an economics course, the economic problem is that our wants are infinite, but our means of satisfying those wants—our resources—are finite. That’s true for the individual, but also for society. The whole point of economics is to help the community deal with this ‘problem of scarcity’—there just isn’t enough land, labour or capital (or, as we’ve come to realise, clean air, clean water or biodiversity) in the world to do all the things we’d like to do. It’s this comparative scarcity that gives resources their price. Only if something is infinitely available (such as air to breath, as we used to imagine) does it come without price. And the price of something, no matter how high, is the right price when it accurately reflects that item’s ‘scarcity value’. It’s because resources are scarce relative to all the uses we’d like to put them to that we have one of the bedrock concepts of economics: ‘opportunity cost’. Everything we do has an opportunity cost because the resources we use to do one thing are no longer available to be used to do anything else. So the opportunity cost of that one thing is the value of the next most desirable thing you could have done with the resources used. Economists’ primary contribution to society is to help it in its eternal battle with the problem of scarcity—that is, to help it find ways to satisfy as many wants as possible from the limited resources available. To help it get more bang for its buck. Economists’ obsession with scarcity explains their obsession with prices (because prices are meant to reflect relative scarcity) and their obsession with productivity (finding ways to extract more output from unchanged inputs of resources) and efficiency (eliminating waste in the use of resources). OK, back to hospital waiting lists. The thing that makes economists uneasy about Medicare is its promise of ‘free’ public hospital treatment to all comers. If something’s free it’s bound to be used to

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excess, to be used wastefully. By charging a price you avoid wastefulness by rationing the availability of the resources being used. By using prices to ration access, you ensure that only people who would really value something will stump up the money to buy it. (But what if they really want it but simply can’t afford it? Economic efficiency’s answer is: tough luck.) The point is that, because resources are scarce, they have to be rationed one way or another. And if you don’t ration by price, you ration by queue. If access to public hospitals really was free, state governments would be writing an open cheque for each of their hospitals. Spending on hospitals would grow even more rapidly than it already is. To cover this ever-expanding cost, governments would have either to keep cutting spending in other areas or keep raising taxes. Because they’re most reluctant to do either, they set a limit on how much they’re prepared to spend on public hospitals each year—a limit economists call ‘the budget constraint’—and make everyone wait their turn for elective (non-urgent) surgery. This gives priority to people with life-threatening conditions who need operations. And it doesn’t just delay everyone’s elective surgery. It probably also causes there to be less surgery than otherwise because some people look at the queue and don’t bother, while some people in the last months of their life die before they get to the head of the queue. So waiting lists are a deliberate strategy to limit the growth in government spending on health care. They exist in almost every other country and it’s impossible to imagine a time when governments will cease using them as a crude way to limit public spending.

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chapter 4

ECONOMISTS’ OBSESSION WITH PRICES

The key to understanding microeconomics is to realise that its overwhelming focus is on the role of prices. The standard ‘neoclassical’ model of markets assumes—and many, if not most, economists believe—that prices are the single most powerful factor explaining economic behaviour. If economists wore T-shirts they’d say, Prices Make the World Go Round. It’s prices that are expected to reconcile the unending conflict between supply and demand. It’s prices—whether they’re prices you have to pay or prices you receive, such as wages—that do most to motivate our actions. So basic microeconomics strips away almost all other factors so it can get to the heart of the matter: the monetary factors likely to influence prices and thus determine people’s behaviour. It’s prices—or the change in them—which act to bring markets into ‘equilibrium’ or balance. This, it’s argued, is because prices act as signals to both sides of the market: the buyers (consumers) who provide the demand for a particular item, and the sellers (producers) who supply the item. When the price of an item rises, this sends signals to both buyers and sellers. The signal to buyers is: buy less. Be more economical in your use of this item because it’s now more expensive. Look for 15

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cheaper substitutes for it. The signal to sellers, on the other hand, is: produce more. Crank out more of the stuff because it’s now more profitable to do so. What happens when buyers and sellers respond to these signals? Demand declines while supply increases. And what does that do? It causes the price to fall back to roughly where it was in the first place. It returns the market to equilibrium. Have you heard of ‘the price mechanism’? Well now you know what it is and how it works. As part of all this, economists don’t share the consumer’s prejudice that low prices are the best prices—although, by the same token, nor do they share the producer’s prejudice that high prices are the best. No, what economists want to see is the ‘right’ price, and they don’t much care whether that happens to be high or low. What is the right price? The price that exactly reflects the item’s ‘resource cost’—the cost of the resources of land, labour and capital that were used up to produce the item. That cost will reflect the ‘scarcity value’ of those resources—how easily obtained they were relative to the degree of demand for them. Making allowance for the cost of the resources embodied in the item will include allowing for the cost of capital—profit. But not the maximum profit, only the ‘right’ profit. Which is? The profit just high enough to keep that capital producing this item rather than some other item. And that will be the profit equal to the next most profitable alternative use for the capital. In other words, its ‘opportunity cost’. The point is that when the price is lower than the true resource cost of the item, people will be encouraged to overconsume that item. This will waste resources that could have been used to produce some other item that would have yielded people greater satisfaction. But where the price is higher than the resource cost of the item, this will lead to underconsumption. The excess price discourages people from consuming as much of the item as they’d

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really like to, so that resources are directed to producing some other item that yields people less satisfaction. Even at this elementary level, however, the operation of prices isn’t as simple as that. For one thing, though the quantity of an item that we demand is likely to be influenced by changes in the price of that item, the degree to which the quantity changes can vary for different items. Economists call this the ‘price elasticity of demand’. Where a small percentage change in the price (in either direction) leads to a larger percentage change in the quantity demanded (in the same direction), demand for the product is said to be ‘elastic’. But where a small change in the price leads to a smaller change in the quantity demanded, demand for the product is said to be ‘inelastic’. Demand for the basic necessities of life will generally be fairly inelastic—that is, changes in price will have little effect on the quantity demanded—provided there aren’t close substitutes readily available. Red meat, for instance, may be a basic necessity, but if its price rises by much people will switch to chicken—and vice versa. Petrol, however, is a good example of a basic item for which demand is inelastic. Why? No close substitutes unless you go to the considerable expense of switching to LPG. By contrast, demand for luxury items is likely to be highly elastic. That is, changes in price will have a big effect on the quantity demanded. Let’s go back to that first explanation I gave of how changes in prices send signals to buyers and sellers as part of a price mechanism that restores markets to equilibrium. It’s clear that, in practice, how well the price mechanism works to eliminate ‘disequilibrium’ will be heavily influenced by the price elasticity of the particular product involved. If demand is elastic, the mechanism will move quickly and easily in textbook fashion, whereas if it’s inelastic the good outcome promised by the textbook may take much longer— if it ever happens. Guess what? When we turn from microeconomics to macroeco-

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nomics—from looking at individual markets to looking at the whole economy—we discover that much of the disagreement between adherents of the neoclassical and Keynesian schools of macroeconomic thought boils down to different assumptions about the elasticity of prices. The neoclassically inclined assume that, for the most part, prices are pretty elastic, whereas the Keynesians assume that, for the most part, prices are pretty inelastic. So while the neoclassicists assume that any malfunctioning— disequilibrium—in the economy will be caused by prices being at inappropriate levels, Keynesians are more inclined to assume that, since prices tend to be inelastic and, in important cases, ‘sticky’ (hard to move down), the solution to disequilibrium is to focus rather on changing quantities. You can see this difference of view clearly in the rival groups’ approach to the problem of unemployment. Neoclassicists’ conclusion is that, if people who want to work aren’t gaining employment, the obvious cause of the problem is that wage rates (prices) are too high and the obvious solution is for wage rates to fall until the labour market ‘clears’ (all sellers find buyers). In contrast, Keynesians believe it’s very hard to lower wage rates and, in any case, they’d probably have to fall a long way to induce employers to hire many additional workers. So, since the demand for labour is derived from the demand for goods and services, the real problem is ‘deficient demand’ and the solution is to stimulate demand in the usual Keynesian ways so that there’s an increase in the quantity of labour demanded. Whatever side you choose to take in that debate, don’t forget my key point: to make sense of economics, you have to remember that it’s obsessed by prices.

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par t II

THE LABOUR MARKET

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chapter 5

HOW THE LABOUR MARKET WORKS

In the mid-1990s, a newspaper columnist wrote that it had been obvious for at least 25 years that we were not going to have enough jobs to satisfy the demand for them. Three factors have made this inevitable, he argued. First, the impact of the women’s movement had increased the number of women wanting to work. Implication: a dramatic increase in the pool of available labour. Second, the era of microeconomic reform. Implication: enhanced productivity, which means getting the work done by fewer people. Third, technology continues to replace people with machines. Implication: less work for people to do. So, is that what it boils down to? Is that why for so long unemployment seemed to be rising inexorably? A much higher proportion of the population wanting to work, but a lot less work to be done? Sorry, but it’s not like that. Our long-standing failure to restore full employment isn’t so easily explained, nor is our future as apocalyptic as some paint it. Rather than rely on impressions, let’s see what we can learn from the facts—and from a little economic theory. For a start, the pool of available labour has certainly grown over the past 35 years, but it hasn’t increased as dramatically as you may think. It’s true that 21

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the proportion of married women seeking paid employment has increased remarkably. Between August 1970 and August 2005 it rose from 35 per cent to 57 per cent. But that’s not all that’s happened. Many people are retiring earlier and most young people are staying much longer in full-time education. When you put these conflicting trends together, you discover that the proportion of the total working-age population wanting to work has risen in that 35 years just from 61 per cent to 64 per cent. A far more important factor explaining the growth in the number of people wanting to work—from 5.5 million to 10.5 million—is simply the growth in the population. And there’s nothing particularly alarming about a growing population, because every extra person is a consumer and so adds to the amount of work needing to be done to supply them with the goods and services consumed. So the ‘pool of available labour’ has grown, but not dramatically or alarmingly. What, then, has happened to the amount of work needing to be done? Have microeconomic reform and new technology caused it to fall? It’s not surprising that many people assume it has. It’s true that micro reform is aimed—among other things—at enhancing productivity, and that raising the productivity of labour means the same amount of goods or services can now be produced by fewer people. It’s equally true that much new technology is aimed at replacing people with machines. This, too, means the productivity of labour increases. We hear continually of big businesses ‘downsizing’ and governments making workers redundant by the thousands. So what are the facts? Has the total amount of work been falling? No, just the reverse. During the 1970s, the total amount of paid work performed per week rose by 10 per cent. During the 1980s, it rose by 23 per cent. During the 1990s, it rose by 14 per cent, and during the first half of the 2000s it’s grown by 5 per cent. Putting that together, whereas in 1970 we did 208 million hours of paid work a week, in 2005 we did 347 million hours—an increase of

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two-thirds. Translating that into bodies, the number of people with full-time jobs rose from 4.8 million to 7.1 million and the number with part-time jobs rose from 600 000 to 2.9 million. So the amount of work needing to be done, and being done, has been increasing, not falling—despite all the micro reform and all the labour-saving technology. Why? Because, as any school student of economics could tell you, our wants are infinite. There’s no limit to the number and range of goods and—more particularly—services we’d like to consume if only the resources were available to permit it. When we find ways of producing the same quantity of goods using fewer resources—when we raise our productivity—we use those freed resources either to produce more of the same thing or more of something else. So most of the people laid off by governments or big business (or small business, for that matter) get taken on by employers elsewhere in the economy. That’s the way it’s supposed to work, and that’s the way—for the most part—it does work. If you find this surprising, what surprises economists is that, for so many people, the penny hasn’t dropped. There’s nothing new about the process we’ve been describing. It didn’t begin 35 years ago, it began 200 years ago. New technology didn’t begin with the Internet or the computer chip, it began with the spinning jenny, Stephenson’s Rocket and the stump-jump plough. Every year since then businesses have been installing ‘labour-saving’ technology. Their pursuit of ever-higher productivity has left us with an infinitely higher standard of living, but what it hasn’t given us is an unemployment rate that’s been rising inexorably for 200 years. What have been rising inexorably are the number of people with jobs and the amount of work being done. As for microeconomic reform, it may sound new but much of it boils down to governments starting to do what businesses have always done.

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It’s true, however, that—especially if you allow for underemployment and hidden unemployment—there has been an upward trend in unemployment since the mid-1970s (though there’s been more cyclical variation around the long-term trend than many people seem to realise). Why? Because the economy has been changing more rapidly than the labour market’s been able to cope with. Because, though most people who’ve lost their jobs have been able to find other ones, some haven’t. The answer isn’t to make the dole a living wage, to get the government to employ people to do things that don’t need doing, to question the morality of two-income families, or to share jobs. It’s to improve the labour market’s ability to ‘recycle’ people from one job to another. We need to improve training and retraining, give special help to the long-term unemployed, and maybe make wages more flexible. Above all, we mustn’t let faulty analysis of the problem lead us to defeatist solutions.

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chapter 6

REFORM OF THE LABOUR MARKET

Australia’s labour market has undergone considerable reform in several stages under both Labor and Liberal governments during the past 15 or more years. The primary goal of the seven versions of the Prices and Incomes Accord running from 1983 to 1996 under the Hawke and Keating Labor governments was to limit the growth in real wages, and so bring real wage levels back in line with the level of the productivity of labour. In this the Accord was highly successful. The reward was very strong growth in employment over the last seven years of the 1980s, although the price was that workers enjoyed very little growth in their real wages during Labor’s term (in marked contrast to the strong growth in real wages during the Howard Government’s term). But Accord Mark IV in 1988 made the first step towards reforming industrial relations and the structure of the labour market with its introduction of ‘award restructuring’. This involved increasing the flexibility with which employers could deploy workers on the shop floor by reducing the rigid ‘demarcations’—rules about the kind of tasks a worker is permitted to perform—between workers in different unions and different industrial awards, and even between workers on different classifications within the same 25

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award. It also permitted ‘multiskilling’—training workers so they are able to perform a range of tasks, as required by the circumstances at the time—and established ‘career paths’ for blue-collar workers, allowing them to progress to higher paid job classifications as they acquired additional training. But the most radical reform under Labor came with Accord Mark VI and the consequent decision by the Industrial Relations Commission in 1991 to facilitate wage bargaining at the level of the individual enterprise. Until then, Australia had a highly centralised wage-fixing system under which virtually all workers in the country received the same percentage pay rise on the same day, as determined by the IRC’s decision in the annual (or six-monthly) ‘national wage case’. The goal of the move to wage bargaining at the enterprise level was to encourage changes to wage rates and working conditions that were tailored to the circumstances of the particular workplace. It permitted some degree of give-and-take between workers and bosses. Those workers who weren’t sufficiently well unionised to engage in collective bargaining would rely for pay rises on the IRC’s annual ‘wages safety-net’ adjustment to the range of minimum wage rates set out in each award. The next major move to reform industrial relations and the labour market came with the incoming Howard Government’s Workplace Relations Act, passed in late 1996 after extensive modification by the Democrats in the Senate. The changes aimed to further the move to bargaining at the enterprise level by limiting the role of the IRC, reducing the number of issues permitted to be covered by awards to just 20 ‘allowable matters’ and introducing a new formalised means of making individual contracts—known as Australian Workplace Agreements (AWAs)—under the supervision of the Office of the Employment Advocate. The new act also sought to greatly reduce the role and power of unions by such changes as outlawing compulsory unionism, making strikes legal only during the negotiation of agreements and banning ‘secondary boycotts’.

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These changes left us in the position where there were three different methods of wage-setting in use. Some people’s wages were set by collectively bargained enterprise agreements, some by an individual agreement and some were still determined only by the provisions of the relevant award. (Note, however, that the operation of the ‘no-disadvantage test’ meant awards still acted as a safety net underlying collective agreements and individual agreements.) In 1990, 68 per cent of employees were in the ‘award only’ stream. By 2004, this was down to 20 per cent. (So only a fifth of workers were directly affected by the IRC’s annual safety-net wage adjustment.) About 40 per cent of employees were covered by collectively bargained enterprise agreements (although less than two-thirds of these employees were covered by federally registered agreements). So that left 40 per cent of employees classified by the Bureau of Statistics as having their wages determined by individual agreement. However, most of these people were merely being paid a wage that was a bit higher than their award specified. Another big chunk were managers and professionals on informal or common-law contracts. Less than 2.5 per cent of all employees were on AWAs. For the most part, individual contracts were more common among small employers, while collective agreements were more common among big employers. In the years after 1996, the Howard Government’s many efforts to make further changes to industrial relations were blocked in the Senate. After it won control of the Senate in the election of October 2004, however, its resolve to institute sweeping change was revived. To date, the main emphasis on reform of the labour market had been on decentralising wage-fixing to the level of the enterprise. With the changes Mr Howard announced in mid-2005, however, the emphasis was on deregulating the labour market. The old industrial relations system has been heavily modified already, but these changes will make it unrecognisable. They have five main objectives: to get the states out of industrial relations, minimise the role of the IRC, get people away from awards, weaken

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the union movement and discourage collective bargaining. For years people have dreamt of having a single, national industrial relations system—rather than a federal and (these days) five state systems—without seeing how it could ever be achieved. Now it’s to become a reality because of a highly unusual combination of circumstances: a Coalition federal government led by an unashamed centralist in John Howard, facing six Labor state governments. The Liberals’ traditional support for states’ rights just doesn’t get a look in. The state governments will oppose the takeover of their prerogative, but Mr Howard’s undoubted constitutional power to legislate for the affairs of companies seems sure to prevail. Under Australia’s traditional and unique system of determining industrial issues by voluntary conciliation or compulsory arbitration, the IRC controlled the system. Not any more. Its power to set minimum wages—both the single national minimum wage and the range of minimums for each job classification set out in every industrial award—will be passed to a new Australian Fair Pay Commission with minimal union representation. You can be sure the Fair Pay Commission won’t cut minimum wages in nominal terms. But you can be equally sure it will cause minimum wages to rise more slowly than they would have under the old commission. So minimum wage rates will fall relative to average earnings and will probably fall in real terms during recessions. The IRC’s power to approve collectively bargained enterprise agreements will be passed to the Office of the Employment Advocate—which formerly was responsible only for AWAs. Whereas collective agreements and AWAs have been scrutinised before being approved, it’s clear that now they’ll be pretty much rubber-stamped. Next, the IRC will lose its power to judge cases of unfair dismissal for all but the employees of big companies (those with more than 100 employees). So the former colossus will be reduced to resolving industrial disputes involving unionised workers and

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simplifying awards as required by the new legislation. It will also lose its ability to decide test cases, such as for paid maternity leave or redundancy pay. You’ll hardly hear of it again. On the face of it, awards won’t be changed much. The 20 allowable matters permitted to be covered in awards are to be reduced to 16, with the removal of jury service, long service leave, superannuation and notice of termination. Each of these matters is already covered by state or federal legislation. No big deal? There’s more. The government will legislate to guarantee four key minimum conditions of employment: annual leave, sick and other personal leave, parental leave and the maximum ordinary hours of work of 38 a week. As well, the government will conduct a review aimed at rationalising the existing ‘award wage and classification structures’. This suggests we’ll end up with fewer job classifications set out in fewer awards, each with its own specified minimum pay rate. But the real blow to the award system—the thing that will end up making it of little relevance to anyone—is the abandonment of the no-disadvantage test. Despite the move to collectively and individually bargained agreements at the enterprise level under the changes to wage-fixing begun by the Hawke Government in the early 1990s, the system of awards remained relevant as the safety net that underpinned workers’ wages and conditions. It was the no-disadvantage test that retained the relevant award as a person’s safety net. Before the commission could approve a collective agreement, or before the Employment Advocate could approve an AWA, they had to satisfy themselves the deal would leave the workers at no overall disadvantage compared with the provisions of their award. In other words, you could be better off, but not worse off. If you gave up some benefit there had to be an adequate offsetting gain. Now, however, the no-disadvantage test is to be replaced by an ‘Australian fair pay and conditions standard’. That is, the collective agreement or AWA can’t provide for pay rates lower than

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those set by the Fair Pay Commission or conditions of leave and standard hours worse than those specified in the new legislation. Get it? The safety net for workers will no longer be their award, but rather the new minimum wage rate and the four minimum statutory employment conditions. This won’t be a problem for well-unionised workers with collective agreements. But nonunionised workers in smaller firms are now more likely to find themselves pushed on to AWAs that do disadvantage them relative to their award. The conditions now up for grabs include overtime payments, shift penalties, weekend rates, leave loading, public holiday loading and redundancy pay. Various aspects of the ‘reforms’ are clearly intended to weaken the union movement (in addition to those already implemented in the Workplace Relations Act 1996 ). The requirement for secret ballots isn’t intended to make unions more democratic, but simply to raise the administrative burden and the delay before workers can go on strike or take other industrial action. The unions’ access to workplaces will be restricted to times and places determined by employers. Unions will be prevented from engaging in ‘pattern bargaining’—seeking identical collective agreements at a range of enterprises—though there’ll be nothing to prevent employers negotiating identical AWAs with each individual. Put it all together and it’s clear the government is seeking to discourage collective bargaining and hasten the spread of its AWA brand of individual contracts. The award system and the Industrial Relations Commission worked to strengthen unionised workers, but also to protect workers who weren’t in the union. Now only vestiges of that system will be left. Employers are far more powerful than individual workers. So, for well over a century, workers have formed unions so as to bargain collectively with employers, thereby improving their bargaining power. The attack on unions and the encouragement of individual contracts is intended to shift bargaining power back to employers.

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chapter 7

THE LABOUR MARKET’S CHANGING FUTURE

Slowly, slowly the message is seeping into the public’s mind that the boring old ‘ageing of the population’ is likely to revolutionise the state of the job market. And I hope it’s getting through to our young people that their medium-term future in the world of work is a lot brighter than most oldies have led them to expect—which means it’s a lot brighter than that faced by education leavers over the past 30 years. As ageing and insensitive baby boomers never tire of pointing out to the young, if you go back to the 1960s you’ll find we had a labour market that was like something out of a dream. The rate of unemployment rarely got higher than 2 per cent and there were frequent periods of ‘over-full employment’—more job vacancies than there were people to fill them. Young people could leave school when they wished and walk straight into a full-time job. There was no great competition to get into uni. In short, it was an era in which the supply of labour had trouble keeping up with the demand for it. But it all came to a screaming halt in the mid-1970s when the balance swung around and the supply of labour moved ahead of demand. We entered the period everyone knows about, with high and rising unemployment and young people leaving school or university often 31

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encountering difficulty finding a decent berth. As far as most people are concerned, we’re still in that dysfunctional period, with little reason to expect things to change—except, perhaps, for the worse. But here’s the point: the ageing of the population means things are going to change for the better—not overnight, but over the coming years. The balance will swing back, so that the demand for labour is a much better match for the supply of it. So the coming 40 years are likely to be very different from the past 40. We can piece together a picture of just how different they may be from the Howard Government’s Intergenerational Report of 2002 and from several speeches by the Secretary to the Treasury, Dr Ken Henry. The forward-looking figures I’ll quote are derived from the projections in that report—which means they describe not the future so much as ‘a possible future, but within a wide band of uncertainty’. What we’re doing, of course, is looking at the influence of demography—change in the size and structure of the population— on the state of the labour market. Demographic change has a big influence over the balance of supply and demand for labour. Because everyone who’s alive is a consumer of goods and services, the rate of growth in the population is a major factor determining the growth in the demand for labour (to produce those goods and services). But the first factor determining the growth in the supply of labour is the rate of growth in the population that’s at the right age to work—which we’ll define here as people aged between 15 and 64. Now, because of the great boom in the number of babies born in the 15 years after World War II, the past 40 years saw the working-age population grow a lot faster than the population generally. Whereas the country’s general population grew by 87 per cent (from 10.5 million to 19.6 million), the working-age population more than doubled, growing by 105 per cent. That single comparison goes a long way towards explaining why things became a lot

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tougher in the labour market in the past 25 years or so: the underlying supply of labour was growing much faster than the underlying demand for labour. But now let’s look at Treasury’s projections for the coming 40 years. Between now and 2042, the population is expected to grow by 29 per cent (to 25.3 million), whereas the working-age population is expected to grow by only 17 per cent. So, although the growth in the underlying demand for labour will be a lot slower, the growth in the underlying supply will be slower still, causing demand to outstrip supply. (Why the turnaround? The lower growth in the general population will be caused by a lower birth rate that’s not offset by a particularly high rate of immigration. The working-age population will grow at a slower rate than the population generally for three reasons: because the steady fall in the birth rate since 1961 means a lower proportion of young people joining the working-age population; because the great bulge of baby boomers will be spilling into the over-64 age group; and because people already in that age group will live longer.) But wait, there’s more. Just because you’re the right age to work doesn’t mean you actually participate in the labour force by taking a job or actively seeking one. Over the past 40 years, the proportion of the working-age population (here defined as everyone 15 years and older) choosing to participate in the labour force rose from 58 per cent to 64 per cent. Because of a fall in participation by men, this increase is more than fully explained by an increase in female participation from 36 per cent to 55 per cent as married women chose to continue in paid employment. So there we have a second major factor—the economic emancipation of women— combining with demographic change to accelerate the growth of labour supply relative to labour demand over the past 40 years. What about the next 40? This gets a bit tricky. Treasury projects that the rate of participation will rise somewhat in each individual age group. So, if that was all that happened—if the average age of

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the working-age population didn’t rise—the participation rate would creep up from 64 per cent today to 66 per cent in 2042. But, of course, the average age will rise and, in particular, the bulge of baby boomers will move into those age groups where the rate of participation is always much lower (even if it isn’t quite as low over the next 40 years as it was over the past 40). So, in fact, Treasury sees the participation rate falling from 64 per cent to 56 per cent. Get the point? Whereas in the past 40 years both demography and women’s emancipation worked to cause the supply of labour to outstrip the demand for it, in the coming 40 demography will work to cause demand to outstrip supply. In theory, of course, the price of labour was supposed to have fallen over the past 40 years to bring supply and demand into balance. But that didn’t happen, so the average rate of unemployment rose from 2 per cent in the 1960s to 4 per cent in the 1970s, 8 per cent in the 1980s and 9 per cent in the 1990s. In contrast, Treasury projects that unemployment will average 5 per cent—or maybe even 4—over the next 40 years. In practical terms, all this means that there’ll be a relative decline in the number of young people joining the workforce from school or university, which should make it a lot easier for them to find their feet. At the other end of the spectrum, the shortages of experienced labour should revolutionise bosses’ attitudes towards older workers. If so, the future can’t come fast enough.

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par t III

THE FINANCIAL MARKETS

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chapter 8

HOW INTEREST RATES AFFECT DEMAND AND INFLATION

Whenever the Reserve Bank raises the official interest rate—usually by 0.25 percentage points—it’s always for the same reason: it wants to avoid the economy growing too fast and causing inflation to get too high. That’s the ‘why’, but what about the ‘how’? What’s so magical about interest rates? How exactly do they affect the rate of growth in economic activity—spending and production—and the rate of increase in prices? I’m glad you asked, but it’s a long story. Modern monetary economists have identified no less than six different ‘channels’ through which a change in interest rates works to affect, first, economic activity, and then inflation. But I’ll spare you the full list and stick to the four main ones. Monetary policy’s first and most basic transmission channel goes by the imposing name of the ‘inter-temporal substitution effect’. It’s simpler than it sounds. Consumers are continually deciding whether to buy major items now, or to buy them later. Similarly, businesses have to decide whether to spend on new investment now, or wait till some time in the future. When you think about it, you realise that the rate of interest is actually the cost of spending now rather than later. Even though I 37

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don’t have the money to pay for it, I can buy a car (or a house) now, simply by borrowing the money. But the cost of bringing forward my purchase of the car is, obviously, the interest I have to pay on the loan. And even if I do have the money to pay cash for the car, it’s still true that the cost of my decision to buy it now rather than in, say, a year’s time, is the rate of interest. How so? Because I forgo the interest I could have earnt by leaving the money in the bank. It’s the ‘opportunity cost’. Enter the Reserve Bank. By moving the official interest rate up or down, it’s able to shift all short-term and variable interest rates in the economy up or down by roughly the same amount (see Chapter 9). This means it’s able to manipulate the cost of spending now rather than later. And this means it’s able to affect the decisions households and businesses make about their spending. If it thinks spending (‘domestic demand’) is too weak, it can encourage people to bring forward their spending plans by cutting interest rates. If it thinks spending may soon be growing too strongly, it can encourage people to defer their spending by raising interest rates. (Inter-temporal means ‘between time periods’. So inter-temporal substitution is just a fancy way of referring to our decisions about which time period to do our spending in.) But that’s not the only way a rise in interest rates tends to dampen economic activity. The second channel is the ‘cash flow effect’. A rise in interest rates makes it harder for intending home buyers to fit the mortgage payments within their weekly budgets, so some will have to abandon their plans. And if repayments rise for existing home buyers, this will leave them with less cash to spend on other things. Similarly, higher interest payments will worsen the cash flows of business borrowers, making them less inclined to spend on investment and more inclined to engage in cost-cutting. Of course, some households—particularly those with older people—have more money in bank deposits and the like than they owe. So a rise in interest rates will actually improve their cash flows,

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encouraging them to increase their spending rather than reduce it. Overall, however, the household sector pays out more on its borrowings than it receives in interest on its lending, so the net effect of a rise in interest rates is to worsen the cash flows of households. The third channel through which a rise in interest rates works to dampen economic activity is the ‘exchange rate effect’. When our interest rates rise relative to those on offer in other countries, this should attract more inflow of foreign capital, which pushes up the value of our dollar. (Note that this effect—and all the others—is based on the assumption that other things remain equal. In practice, they rarely do.) The rise in the exchange rate lowers the price of imports, which makes it harder for our import-competing industries to make sales in the domestic market. It also reduces the competitiveness of our export industries. The eventual result is slower growth in ‘aggregate demand’ (GDP) because we’re producing fewer exports and import-replacement goods. The fourth channel through which a rise in interest rates helps to slow the growth in economic activity is the ‘expectations effect’. These days, increases in the official interest rate get lots of attention from the media—often including weeks of mounting speculation in advance of the dastardly deed. And no sooner is an actual increase announced than people like me are speculating about how much more there is to come. All this gloomy talk can have a psychological effect on the ‘confidence’ of consumers and businesses—an effect on their expectations about what lies ahead for the economy—that’s separate from, and additional to, the actual effect of the rate rise. People start to realise that the good times aren’t likely to roll on quite so rapidly for much longer. They wonder whether now’s the right time to lash out on some big new commitment, or whether it would be smarter to hang off for a while. But, on the brighter side, they also become more confident of the Reserve Bank’s determination to stop the inflation rate rising

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too far. It’s so determined it’s willing to cop the flak that goes with raising rates. And if people expect inflation to stay low, that itself helps to keep it low. Why? Because people tend to act on their expectations. Businesses don’t raise their prices as far and unions demand smaller wage rises. So far, I’ve described some of the channels by which a rise in interest rates tends to dampen economic activity, but not said how this helps to keep inflation low. It’s straight demand-and-supply. When demand is growing fast and suppliers are having trouble keeping up, their natural response is to raise their prices. So dampening demand helps to keep prices from rising too much. But, you may ask, how are all these wonders to be brought about by an interest rate increase of a mere 0.25 percentage points? They won’t be. Such small changes are usually part of a series. So why doesn’t the Reserve Bank do the whole lot in one go? Because it’s never sure how much will be needed, because it doesn’t want to scare the pants off us and because it’s hoping it won’t need to do all that much.

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chapter 9

HOW THE RESERVE BANK INFLUENCES INTEREST RATES

The public’s understanding of how interest rates work is improving. It seems everyone now knows that when the Reserve Bank moves official interest rates, the banks’ interest rates are supposed to follow. But this process doesn’t happen by magic. So how does it happen? What are ‘official interest rates’? How does the Reserve Bank change them? And how does a change in official interest rates lead to a change in the banks’ interest rates? There is, in fact, only one ‘official’ interest rate. Its real name is ‘the cash rate’ and it’s the cost of borrowing ‘cash’ overnight in the short-term money market. That little word ‘cash’ doesn’t mean what you think it means. It’s a nickname for the reserves or ‘exchange settlement funds’ the banks keep in their exchange settlement accounts with the Reserve Bank. (So, in this context, ‘cash’ doesn’t mean notes and coins. The bankers’ word for notes and coins is ‘currency’.) The banks need this special kind of ‘cash’ to settle debts between themselves arising from their customers’ exchange of cheques. The banks also need cash to settle their debts to the Reserve Bank. Such debts arise because the Reserve acts as the federal government’s banker, or because the banks have bought foreign currencies from 41

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the Reserve in the foreign exchange market. And when the Reserve is in debt to the banks (either in its role as the government’s banker or because it has bought foreign currencies from the banks), it settles those debts by putting cash back into the banks’ exchange settlement accounts. The trick is that, though the banks have a great demand for cash, the supply of cash is controlled by the Reserve. It can increase the supply of cash available to the banks by buying second-hand commonwealth government securities (CGS) from the banks (or their customers) because it pays for those securities with cash. Similarly, it can reduce the supply of cash by selling CGS to the banks. The Reserve’s buying and selling of CGS to manipulate the supply of cash available to the banks is known as ‘open market operations’. It conducts these market operations every day. Why? To maintain the balance between the demand for and supply of cash which holds the price of cash—the interest rate on borrowing cash overnight; the ‘official’ interest rate—where it wants it to be. The Reserve holds the cash rate steady for months at a time. But occasionally—say, several times a year—it decides to change the cash rate. Let’s say that, at 9.30 am on the first Wednesday of the month, the Reserve announces it has decided to cut the cash rate by 0.25 percentage points. How does it bring this about? By means of its open market operations. The Reserve cuts the official interest rate when it wants to encourage more spending—on consumption and investment—in the economy; it raises official interest rates when it wants to discourage spending in the economy. But, obviously, for this to happen the change in the official interest rate has to spread to the interest rates charged and paid by the banks and other financial institutions. So how does this come about? The first thing to happen is that the change in the cash rate quickly brings about a similar change in the interest rates in the ‘commercial market’ (also known as the ‘wholesale market’). The

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commercial market is where big companies, pension funds and other institutional investors borrow and lend big sums using bills of exchange that run for 90 or 180 days. Why should a change in the overnight cash rate cause a similar change in the interest rates on 90- and 180-day bills? Because 90 days is the same as 90 nights. If the cost of borrowing money for one night has fallen, and you expect it to stay there for at least 90 nights, why would you pay more to borrow for 90 days? And why would you lend for less? Naturally, the same logic applies if the cost of borrowing overnight is expected to stay the same for 180 nights. But how does this affect the interest rates charged and paid by the banks? It affects them because of the many links—direct and indirect—between the commercial market and the ‘retail market’ (inhabited by you and me) where the banks do most of their business. For a start, the banks borrow in the commercial market well over half the funds they subsequently lend. They do so by means of bills and ‘certificates of deposit’ (which are essentially the same thing). So, to this extent, a fall in the interest rates in the commercial market reduces the banks’ ‘cost of funds’—the average interest rate the banks pay on the money they borrow. As well, the banks will be able to cut the interest rates they pay on fixed deposits and cash management accounts. Why? Because the fall in rates in the commercial market will cut the rates that rival financial institutions are prepared to pay on their investment products that are in competition with the banks’ fixed deposits and cash management accounts. These alternative products include finance company debentures and unsecured notes, and deposits with cash management trusts. And, in theory, the banks should also be able to cut the interest rates they pay on other retail deposits, including ‘transactions accounts’ such as cheque and savings accounts. Why? Because the banks don’t face much competition in the provision of transactions accounts, so customers have to take what they get. It’s true that the

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banks face a little competition in this area from building societies and credit unions, but those institutions have the same desire as the banks to cut their deposit rates. So, putting it all together, the fall in interest rates in the commercial market either directly causes a fall in the banks’ ‘cost of funds’, or it allows them to bring about a fall in their cost of funds. That covers the effect of a fall in official interest rates (and the consequent fall in commercial interest rates) on the price the banks have to pay on the funds they borrow. But why should it also lead to a fall in the interest rates the banks charge on their lending? Why can’t the banks just pocket the saving they’ve made? Because there are links between commercial interest rates and the rates the banks charge their retail borrowers. For instance, the interest rate banks charge on loans to big businesses can’t get too far away from the rates applying in the commercial market because those businesses would switch to borrowing directly from the commercial market if they did. And, these days, the interest rates banks charge on variable-rate home loans can’t get too far away from commercial rates either (Figure 9.1). Why not? Because the banks’ rivals in the market for home loans—the ‘mortgage managers’—set the interest rates they charge at a margin above the prevailing interest rate on 90-day bank bills. It’s true, however, that the less the competition, and the weaker the link to the commercial market, the less pressure there is on the banks to cut the interest rates they charge in line with the fall in official interest rates. This is the case with interest rates on credit cards. The banks face little competition in this market and the links to the commercial market are weak. So all this explains why it’s reasonable to expect that a fall of 0.25 percentage points in official rates will lead to a fall of 0.25 percentage points in the main interest rates banks charge their customers. There’s one last point to note. Though it’s reasonable to expect

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20 18

Interest rates (%)

16 Standard bank variable mortgage rate

14 12

90-day bank bill rate

10 8 6 4

Reserve Bank cash rate

2 0 85

87

89

91

93

95

97

99

01

03

05

Year

Figure 9.1

How interest rates move

Source: RBA

the change in bank interest rates to be the same as the change in the cash rate, it’s not reasonable to expect the level of bank interest rates to be the same as the level of the cash rate. The rates banks charge will always be higher than the cash rate because of differences in the risk associated with bank lending and differences in the costs of administering the loan—as well, of course, as the banks’ profit margin.

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chapter 10

REAL INTEREST RATES AND EXPECTED INFLATION

When the Reserve Bank cuts the official interest rate, does that mean monetary policy has been eased? Not necessarily. In everyday discussion, most economists (and yours truly) speak of the Reserve’s decisions to change the official cash rate as being synonymous with changes in the ‘stance’ on monetary policy. A cut in the cash rate is regarded as an ‘easing’ of policy; an increase is regarded as a ‘tightening’ of policy. (Easier monetary policy should encourage people to spend more and produce more, whereas tighter policy should discourage spending and production.) When we think this way we’re assuming that changes in the stance of policy can be judged from changes in the level of nominal interest rates. (Nominal interest rates are the ones we see and pay.) But, strictly speaking, it’s not that simple. According to economic theory, it’s not nominal interest rates that have the most influence on people’s behaviour, but real interest rates. The real interest rate is the nominal rate minus the expected inflation rate. (Note the word ‘expected’—some people forget to include it in their definition.) Why is it the real interest rate that matters? Because both borrowers and lenders are aware that inflation reduces the purchasing power of money. 46

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If you lend someone some money for a year, you know that the money she repays you in a year’s time will buy less than it did when you lent it to her. How much less? You don’t know until the year’s over. You can only work on what you expect the rate of inflation to be. Let’s say you expect that the general level of prices will rise by 3 per cent. This means you’d be a mug to lend her your money at an interest rate of anything less than 3 per cent. If you did, you’d end up out-of-pocket ‘in real terms’. And if you charged her only 3 per cent you’d be neither better nor worse off—again, in real terms. You’d have given her something valuable—the use of your money for 12 months—without her giving you anything in return. So your decision about whether or not to lend her your money will turn on how much she’s prepared to pay above your expected inflation rate—that is, the real interest rate she’s offering. And her decision about whether or not to borrow the money will turn on the same considerations. She won’t worry about paying you the expected inflation rate because she knows that borrowing the money now will allow her to buy whatever it is she wants to buy while prices are lower than they’ll be in a year’s time. She’ll be able to repay you with money that has less purchasing power than the money you lent her, so paying you 3 per cent in ‘inflation compensation’ will merely leave her square—in real terms. No, what she’ll worry about is the interest rate you’re charging above the expected inflation rate—the real rate. So, when you trace it through, you see that the decisions of both borrowers and lenders turn on the level of real interest rates. It’s the real rate that counts. And what this suggests is that we’d get a more accurate measure of the stance of monetary policy—whether it’s encouraging or discouraging borrowing and, hence, spending—if we looked at what policy was doing to the level of real interest rates rather than nominal rates. Another way of making the same point is to say that, when we judge the stance of policy by looking at the change in nominal

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interest rates rather than real rates, we’re making the unconscious assumption that the expected inflation rate hasn’t changed. Get it? If there’s been no change in inflation expectations, then comparing real rates and comparing nominal rates will give you the same answer. But if there has been a change in inflation expectations in recent times, we need to take account of it when we make judgments about what’s been happening to the stance of policy. In an ideal world, I would now quote you the latest figure for the expected inflation rate and then compare it with what it was six months or a year ago. Unfortunately, there is no single, allencompassing measure of inflation expectations. (Which goes a long way towards explaining why economists have to keep reminding themselves to take account of such expectations. It also explains why you often see economists taking the naughty shortcut of measuring real interest rates by subtracting the current actual inflation rate rather than the expected rate.) When we want to see what’s happening to expected inflation, we’re obliged to study a range of imperfect measures of the expectations of different players within the economy. One obvious measure of expected inflation may be obtained by taking the average of business economists’ forecasts for inflation. A crowd called Consensus Economics does a monthly survey of a range of economists and publishes the average of their forecasts. One indicator of the inflation expectations of players in the financial markets is given by the difference between the market yield on ordinary ten-year Commonwealth bonds and the market yield on indexed ten-year Commonwealth bonds. But the inflation expectations of ordinary businesspeople are probably more important than the expectations of players in the financial markets (or the economists they employ) because businesspeople have more influence over the prices of the goods and services we buy. Again, there are various measures to pick from, none of which is wildly satisfactory. The National Australia Bank’s quarterly business survey

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includes a question on what inflation rate respondents think Australia can maintain for the 2000s. Turning to the inflation expectations of consumers, the best measure available comes from the Westpac–Melbourne Institute monthly survey of consumer sentiment. Unfortunately, the survey results show no sign of improvement in inflation expectations. Consumers’ median expected inflation rate has been steady at around 4 per cent since the start of the 1990s. Indeed there’s been only one significant shift over the past 20 years. From the mid1970s until the early 1990s, consumers tended to expect inflation of around 10 per cent. Since then, they’ve expected 4 or 5 per cent—which means that their expected inflation has continuously exceeded actual inflation by 1 or 2 percentage points. But this apparent lack of price consciousness on the part of consumers doesn’t fit with the experience of retailers, who’ve found that heightened competition has made it much harder for them to raise their prices than it used to be. Back to the main argument. If expected inflation falls while nominal interest rates remain unchanged, then real interest rates have risen and the stance of monetary policy has tightened without the Reserve Bank lifting a finger. Similarly, if expected inflation rises while nominal interest rates are unchanged, real interest rates have fallen and the stance of monetary policy has loosened without the Reserve lifting a finger. It follows that, when the Reserve does change the official interest rate, we should check what’s been happening to inflation expectations before we decide whether the stance of policy has been tightened, loosened or left unchanged.

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chapter 11

THE DOLLAR GOES UP AS WELL AS DOWN

The public’s understanding of our floating exchange rate is dogged by two major misunderstandings: that the dollar just keeps going down and that a falling dollar is bad, while a rising dollar is good. The media have a lot to answer for in pandering to—and thus reinforcing—these misconceptions. It’s true that the present value of the dollar is a lot lower today than it was in 1970, when it stood at $US1.10 and 100 on the trade-weighted index. What’s also true, however, is that since the dollar was allowed to float in 1983, its value has oscillated around an average of US71c and 58 on the TWI. So the dollar goes up as well as down. You could be forgiven for not realising that, however, for the simple reason that falls in the dollar tend to be reported on the front pages of newspapers whereas rises are religated to the business pages. Why this double standard? Because the media know their customers find bad news more interesting than good news. And the media share the popular belief that a fall in the dollar’s value is bad. It’s certainly true that—in principle, at least—a fall will raise the prices of imported goods and services and make overseas trips more expensive, whereas a rise lowers the prices of imports and makes 50

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overseas travel cheaper. There’s a lot more to it than that, however. For one thing, raising the prices of imported goods makes it easier for Australian producers—particularly manufacturers—to compete against imports in the domestic market. For another, a fall in the dollar makes it easier for our exporters—farmers, miners, manufacturers, the inbound tourism industry and other service exporters—to compete on overseas markets. This is because, where exports are priced in Australian dollars, they will now be cheaper to foreigners. Alternatively, where exports are priced in foreign currencies, the prices they fetch will now convert into more Australian dollars without any change in the cost to buyers. This will either make such exports more profitable to Australian producers or allow them to lower their foreign currency price without loss of profit margin, thus permitting more items to be sold. Putting together the effect on imports and the effect on exports, it’s clear that a fall in the dollar makes our import-competing and export industries more price competitive internationally. Conversely, a rise in the dollar worsens the international competitiveness of our export and import-competing industries. Improved price competitiveness ought to lead to an increase in the output of our exporters and import competers, thus increasing real GDP. It follows that a fall in the dollar serves as a source of external stimulus to the economy, whereas a rise in the dollar has a contractionary effect. In a sense, a fall in the dollar has a similar effect on GDP to a cut in interest rates, while a rise in the dollar has a similar effect to a rise in rates. So, does this mean the popular perception that a fall in the dollar is bad and a rise is good is exactly the wrong way round? No. It means that, as with many things in the economy, a fall in the dollar carries both advantages and disadvantages, while a rise carries the opposite set of advantages and disadvantages. Don’t forget that, because of its effect on import prices and its stimulation of output,

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a fall in the dollar will tend to add to inflation pressure, whereas a rise in the dollar will tend to be disinflationary. The sensible conclusion, therefore, is that whether a fall in the dollar is, on balance, a good thing or a bad thing will depend on the economy’s circumstances at the time. There will be times when a fall (or a rise) is appropriate to the economy’s needs, and times when it’s inappropriate. But just why does the dollar float up at some times and down at others? Economists have their theories, naturally. I should warn you, however, that while some of these theories work well over the long term—say, a decade or more—they don’t work well over the short term. Economists assume that the people who buy and sell currencies in the foreign-exchange market do so in response to news about changes in the ‘fundamentals’—such as inflation, current account balances, commodity prices, interest rates, and so forth. This assumption seems to hold better over the longer term than the short term. In the short term, many people trade currencies for reasons that have little to do with the fundamentals. There is a lot of speculative trading, ‘chartism’ (the belief that, when you plot prices on a chart, they will move in ways that conform to previous patterns) and ‘momentum trading’. Momentum trading means buying currencies—or shares, or any other financial asset—simply because their price has been rising, and selling them simply because their price has been falling. It’s obvious that if, in any period, there are enough traders engaging in momentum trading, their actions will prove to be selffulfilling prophecies. Prices will rise because they’re rising or fall because they’re falling. Such behaviour by traders helps explain the common phenomenon of currencies and other financial asset prices ‘overshooting’—moving further than they should in the direction dictated by the fundamentals. Most economists believe, however, that eventually the fundamentals will reassert themselves, moving prices back to where they should be.

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The most venerable theory of exchange rates is ‘purchasing power parity’. PPP says that, over time, exchange rates should adjust to ensure the prices of particular goods are the same in every country. This means that, to the extent that one country’s inflation rate is higher than another country’s, the first country’s currency should fall relative to the second country’s so as to keep the prices of goods the same in both countries. Over the two decades from 1970 to 1990, Australian consumer prices rose by a cumulative 55 per cent more than consumer prices in the United States. So, to maintain the competitiveness of our industries, this inflation difference required the dollar to depreciate from $US1.10 in 1970 to about US70c in 1990. In fact, it averaged US78c that year, so the dollar’s decline up to that point was more than fully explained and justified by our appalling inflation performance. Since 1990, however, the two countries’ consumer prices have risen at roughly the same rate. If you take our (nominal) exchange rate and adjust it for the differences in inflation performance, you get our ‘real’ exchange rate. And if PPP fully accounted for the factors affecting our dollar, the real exchange rate should have been reasonably steady since 1970. In fact, however, it’s been through quite large swings and, comparing 1970 with mid-2005, it’s fallen by 19 per cent against the TWI (Figure 11.1). A second theory that may help explain the long-term movement in our exchange rate concerns our ‘terms of trade’—that is, the ratio of the prices we receive for our exports to the prices we pay for our imports. The theory says our real exchange rate should fall when our terms of trade deteriorate (so as to discourage imports) and rise when our terms of trade improve (so as to encourage imports). And, in fact, there has been a reasonably close correlation between our terms of trade and the real TWI over the past 30 years. There have been big cycles in the terms of trade, but there has also

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140 130 120 110 100 90 80 70 60 50 40

TWI

PPP

1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 Year

Figure 11.1 The Australian dollar—purchasing power parity versus actual TWI Source: RBA

seemed to be a long-term trend decline. Between 1959 and 1985, they each declined at an average rate of 0.75 per cent a year. This long-term decline was usually explained in terms of the high proportion of our exports represented by rural and mineral commodities. There’s been a long-term decline in the prices we receive for our commodity exports relative to the prices of the manufactured goods that dominate our imports. So the terms-oftrade story does a lot to explain and justify the long-term decline in the exchange rate. In more recent times, however, our terms of trade have improved considerably. And the short-term fit between the movement in the terms of trade and the movement in our exchange rate has not been close. I should tell you that, particularly over the short term, economists have rival theories to seek to explain the dollar’s movement. That is, when one theory doesn’t seem a good explanation for what’s been happening, another theory may fit the facts better. One often-used theory concerns the ‘interest rate differential’—that is, the difference between the level of short-term interest rates in

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Australia and the level in other countries, particularly the United States. The theory says that, where Australia is offering foreign investors an interest rate higher than on offer in other countries, you’d expect this to attract foreign capital inflow to Australia, which would put upward pressure on our exchange rate. Conversely, when our rates are lower than other countries’, you’d expect this to put downward pressure on our dollar. It’s a neat theory, but it doesn’t always work—perhaps because, at the time, the interest rate differential is outweighed by other factors in the minds of currency traders. A rival theory says simply that, in a world of floating exchange rates, you’d expect a country that is growing strongly and is expected to continue growing strongly to have an appreciating currency, whereas a country with weak growth prospects would have a depreciating currency. Why? Well, a country with good growth prospects is likely to be attracting capital inflow, both because its interest rates are higher and the prospects of strong profit growth for its listed companies are better. A country that is slowing would tend to have lower interest rates and company shares that are less attractive to foreign investors. So which among the various theories is right? It’s not clear that any of them is always right, particularly not in the short term. What’s clearest is that economists are having a lot of trouble explaining movements in exchange rates when so many currency traders don’t act in response to news about changes in the fundamentals.

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par t IV

GOVERNMENT AND THE ECONOMY

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chapter 12

MARKET FAILURE AND GOVERNMENT FAILURE

Most people know that the policies advocated by the dreaded Economic Rationalists—and by economists more generally—are based on economic theory about how markets work. But most people don’t know much about that theory. For instance, economic rationalists and economists are often accused of holding the absurd belief that if markets were left to work without any government intervention—‘laissez faire’—the free play of market forces would bring us the best of all worlds. Such a belief would be absurd—which is why no economist holds it. No economist believes that markets do or could function perfectly and all accept the need for government intervention— though some favour more intervention than others and most would want to decide how much case-by-case. Misunderstandings such as this arise because economists engaged in the public debate rarely stop to explain the theory that underlies the positions they’re putting. They know what they’re on about, but none of the rest of us do. But the 1995 edition of the Asian Development Bank’s Asian Development Outlook included a neat little primer on the theory of markets. Let me give you my version of it in the hope that it will give you a better understanding of the theory behind the debate. 59

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Microeconomic theory starts with a simple model of markets in which there is ‘perfect competition’. It says that, in the absence of government intervention, the interaction of self-interested consumers with profit-maximising firms will produce the most efficient allocation of the economy’s resources. That is, those resources will be used to produce the particular combination of goods and services that offers the maximum satisfaction of consumers’ material wants. But to reach this desirable conclusion, the model relies on a host of assumptions (which are each explored in more detail in the paragraphs to follow). Most elementary textbooks list four key assumptions: the market must consist of large numbers of buyers and sellers; every firm must be selling an identical (‘homogeneous’) product; all buyers and sellers must have complete knowledge of all relevant prices, quantities, conditions and technologies; and there should be no barriers that prevent firms entering or leaving the market. To these better-known assumptions, however, the Asian Development Bank adds four more: there should be no spillover or external effects, so that all parties bear the full costs and receive the full benefits of their production and consumption activities; there should be no unexploited economies of scale; all parties must know their own best interests; and there should be no uncertainties or ambiguities. Do those assumptions strike you as realistic? Can you think of a market in which all of them hold true? Of course not. As the bank says, ‘these assumptions are extreme and unrealistic in their literal form’. And that’s why this idealised model of perfect competition is merely the starting point of the theory of markets. ‘Despite these glowing theoretical results’, the bank continues, ‘real-world markets may well be deficient in one or more of the necessary assumptions of the theoretical model and thus may fail to deliver the ideal efficiency that the perfect-competition model promises’.

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The next step in the theory is to identify the circumstances in which markets will fail to deliver the goods. The bank lists at least seven kinds of ‘market failure’. First, market power. If there is only one (monopoly) or a few (oligopoly) dominant sellers in a market, and if entry by new firms isn’t easy, the established sellers are likely to exercise market power. That is, prices will be higher and quantities produced will be lower than those promised by the competitive model. As well, quality may be lower, varieties limited and innovation diminished. Second, ‘externality’ effects. If the actions of producers or consumers affect people outside the market, then the market’s outcomes are unlikely to represent an efficient allocation of resources. In cases where these external effects are unfavourable—the generation of air or water pollution, for instance—the uncorrected market outcome yields too much of the particular activity, with prices that are too low and with too little effort made to reduce the unfavourable spillovers. In cases where the external effects are favourable—such as an innovation or new idea that others can use—the market outcome yields too little of the activity, with prices that are too high and with too little effort made to increase the externality. Third, public goods. A public good is a good or service that is ‘non-exclusive’ and ‘non-rival in consumption’. Non-exclusive means it’s difficult or impossible to prevent people from enjoying the good even though they haven’t paid for it. Non-rival in consumption means the benefits of consumption are available to many users at the same time, at a little extra cost to the producer. And my consumption of the good does nothing to prevent your consumption of it. Examples of public goods are national defence, mosquito eradication campaigns, the police, and many more. Markets will either fail to provide public goods at all, or won’t provide enough of them. Fourth, economies of scale. If firms aren’t producing in high enough volume to exploit economies of scale fully, then their activities won’t achieve allocative efficiency.

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Fifth, incomplete information and uncertainty. If sellers and buyers don’t have complete information about how products work, the alternative products, the range of prices and even about future events, their production and consumption decisions won’t yield efficient outcomes. Sixth, asymmetric information. If, as is often the case, the sellers know a lot more about the product and the market than the buyers do, then market outcomes will not be efficient. Seventh, the ‘second best’ problem. If there are uncorrected market failures in one market, then perfect competition in related markets is unlikely to yield efficient outcomes even in those markets. That’s because all markets are interrelated. It follows that, if a distortion in one market can’t be corrected directly, a second-best solution may be to induce compensating distortions in related markets. It’s because economic theory identifies all these potential forms of market failure that all economists, even the most right-wing economic rationalists, accept the need for a high degree of government intervention in markets to attempt to correct those failures. Every economist who accepts that we need a government (even a government much smaller than we have) also accepts that we need a lot of government intervention because everything governments do involves intervention in one way or another. So evidence of particular instances of market failure has been the traditional justification for particular government interventions to attempt to correct those failures. However, recent developments in the theory of markets have focused on the possibility of ‘government failure’. Government failure arises where government intervention to correct market failure worsens outcomes rather than improving them. If we’re going to talk about real-world markets, we also have to talk about real-world governments. The Asian Development Bank lists at least four sources of government failure. First, ill-defined goals. Governments often have very broad, illdefined and even conflicting goals for interventions. In practice,

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trying to achieve conflicting goals can lead to arbitrary and inefficient outcomes. Second, weak incentives and poor management. With ill-defined goals and the absence of a profit motive, public employees are likely to face weak incentives for good performance. Good management is a scarce skill and is usually highly paid. Where top salaries aren’t high enough, governments find it hard to attract and retain highquality managers, thus worsening outcomes. Third, information problems. Governments may encounter as much or almost as much difficulty in acquiring full information as market participants do. Fourth, ‘rent-seeking’ behaviour. Specific interest groups will seek to use the forces of government to create special favours for themselves at the expense of others in the community. For instance, special subsidies, tax breaks or limits on competition. They invariably seek to justify this behaviour by claiming that it’s in the national interest or even that it would correct market failure. Government departments set up to deal with specific sectors often end up as advocates for producer interests in the sector. That is, they become ‘captured’ by the interests they are supposed to be regulating in the community’s interest. That’s about as much as the theory can tell us about how markets work, why they fail and why government intervention may make outcomes worse rather than better. This leaves economists (and politicians and the electorate) needing to make empirical judgments about whether specific market failures are significant enough to justify government intervention, and whether the benefits of specific interventions are likely to exceed their costs. Most (sensible) economists, while guided by their theory, prefer to make those judgments case-by-case.

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par t V

THE GLOBAL ECONOMY

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chapter 13

HOW GLOBALISATION I S HELPING POOR COUNTRIES

The unceasing claim of the mainly youthful protesters against globalisation is that it involves the rich countries—via ‘transnational corporations’ such as Nike—ripping off the poor countries. But it ain’t necessarily so. Indeed, recent research—much of it prompted by the protests, I suspect—suggests that this claim is the opposite of the truth. The developing countries that have done most to open up to trade and foreign investment are enjoying faster economic growth, rising real wages, falling poverty and, eventually, greater environmental protection. The results of this research are summarised in the book Globalisation: Keeping the Gains, published in 2003 by the Department of Foreign Affairs and Trade’s Economic Analytical Unit. A study by the World Bank examined the performance of 72 developing countries. It ranked them according to the extent to which their trade (measured as exports plus imports) has risen as a proportion of gross domestic product since 1980. It classed the top third of them—which included China, India, Malaysia, Brazil and Mexico—as ‘globalisers’, and the rest as ‘non-globalisers’. It found that the globalisers had grown almost four times faster than the non-globalisers: at an average rate of 5 per cent a year 67

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compared with 1.4 per cent. And they hadn’t done this just by pursuing a policy of export-oriented growth. They’d also opened up to imports. The globalisers had reduced their average tariffs (import duties) by 34 percentage points. Economists can’t actually prove that increased trade causes faster economic growth, but they’re assembling a lot of circumstantial evidence. For instance, another study found that a 1 percentagepoint increase in a country’s trade to GDP ratio is associated with an increase in real GDP per person of between 0.5 and 2 per cent. The analytical unit’s book identifies four reasons why you’d expect increased trade to lead to faster growth. For a start, it encourages countries to specialise and produce in areas where they have a relative cost advantage over other economies. Over time, this helps countries employ more of their human, physical and capital resources in sectors where they get the highest returns in open international markets. This, in turn, boosts productivity and the returns to workers and investors. For example, most developing East Asian economies specialise in producing labour-intensive goods such as clothing, footwear and horticultural products, in which their relatively abundant low-skilled labour supplies give them a . . . wait for it . . . ‘comparative advantage’. (No prize for seeing that coming.) By contrast, Australia specialises in higher value-added services and manufactures as well as agricultural and mineral products, which reflects our generally skilled workforce and abundance of land and minerals. The second reason you’d expect increased trade to lead to faster growth is that exporting allows local producers to access bigger markets, giving them greater economies of scale and thus lower production costs per unit. Third, trade causes the diffusion of new technologies and ideas, thereby increasing local workers’ and managers’ productivity. (And people whose productivity is higher will end up being paid more.) Finally, removing tariffs on imports gives consumers access to

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cheaper products, which increases their purchasing power and, hence, their living standards. It also gives producers access to cheaper inputs, reducing their production costs and boosting their competitiveness. The research results do not defend the volatile flows of ‘hot money’ into and out of developing countries that have been a feature of globalisation. It’s a different story, however, with ‘foreign direct investment’ which is where those wicked transnational corporations bring in money to set up factories and so forth. One study has found that, on average, a 1 per cent increase in this FDI increases growth in GDP per person by almost 0.5 per cent. It’s often claimed that globalisation is bringing about a ‘race to the bottom’. Transnational corporations are forcing down wage rates around the world by transferring their production from the developed countries to whatever developing country they can find that has the lowest wages going. But such fears reveal an ignorance of elementary economics. The more the multinationals pile into developing countries to take advantage of their cheap labour, the more the increased demand for that labour forces up its price. (This explains why the source of cheap, labour-intensive goods from Asia keeps shifting. In the early years after World War II, they came from Japan. Then it was Hong Kong, South Korea and Taiwan. Then it was Singapore, Malaysia and Thailand. Now it’s China. The production moves on when the labour gets too dear.) ‘Strong evidence suggests globalised economies typically offer faster wages and employment growth than inward-looking economies’, the book says. ‘By exporting labour-intensive manufactures and agricultural products, globalised developing countries increase demand for unskilled labour, eventually driving up their wages as surplus labour is absorbed.’ And note this: most studies show that foreign companies pay their workers more than local companies do, particularly in developing countries. In most cases, foreign multinationals also offer

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workplaces and working conditions that are superior to local operations. ‘Where they exist, poor labour standards and the use of child labour usually involve local operators and reflect weak domestic laws and enforcement, rather than globalisation’, the book says. ‘Of the around 250 million children under 14 currently working in developing countries, the great majority work on family farms. Of the remainder, most work in informal service sectors like hawking; relatively few are involved in export industries.’ The rising wages in globalising Asia do much to explain why, since 1980, the number of people in the world living in poverty has fallen by about 200 million, even though poverty increased in non-globalising countries, especially in Africa, and the world’s population grew by 2 billion. Turning to the environment, it’s true that industrialisation can put stress on a country’s environment. But that’s in the early stages of development. We know from the experience of the West that, as incomes rise, environmental outcomes improve again until, typically, they surpass the pre-industrial levels. In other words, there should be a U-shaped relationship between a country’s income levels and its environmental quality. As industry expands, land is cleared, pressure on traditional water supplies increases and industries often produce air, water and solid waste pollution. However, as incomes rise further, environmental quality usually improves, for four reasons. First, rising income per person increases child survival rates and education levels, lowering fertility rates and overall population growth. Second, as incomes rise, people demand a better environment, increasing the pressure for better regulation of pollution and government spending on pollution abatement. Third, as incomes and productivity rise, countries can better afford to increase costs to producers and consumers by employing technologies that are more pollution abating and levying taxes to establish regulatory agencies enforcing anti-pollution laws.

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Finally, as incomes rise, countries can better afford to designate large areas of their land and sea zones as national parks, protecting valuable regions from further encroachment. I suspect some extreme environmentalists would prefer to see the poor people of the world stay poor so their environment remained undisturbed and unpolluted. But if you accept that they have the same right as us to strive for a higher material living standard, you have to understand that the horse goes before the cart. If you concentrate on doing what is necessary to achieve economic growth, higher wages, better education levels and higher environmental standards will follow. But if you seek to go straight to these outcomes—by imposing rich-country labour laws and environmental controls on poor countries—the development process is stymied and the poor countries stay poor (and uncaring about environmental damage). Of course, that just leaves one small problem: is it environmentally possible for all the countries of the world to chew up as many natural resources as only the rich countries now do?

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chapter 14

THE PROS AND CONS OF FINANCIAL GLOBALISATION

The International Monetary Fund is a humbled institution. In 2003 it published a report on the effects of financial globalisation on developing countries that’s the biggest climbdown by an international body in ages. The IMF came under considerable criticism for its mishandling of the Asian financial crisis in 1997–98. It fumbled the rescue of several economies, particularly Indonesia, and imposed onerous conditions that made things worse rather than better. A separate criticism, however, was that right up until the crisis, it had been pressuring the developing countries to open up their economies to the flows of foreign capital whose sudden reversal caused all the trouble. This report, by the IMF’s then chief economist, Kenneth Rogoff, re-examines the wisdom of that policy prescription and finds it wanting. It’s important to realise that ‘financial’ globalisation refers not to increased trade between the developed and developing countries, but to increased flows of financial capital. It’s about opening up the capital account of the country’s balance of payments, not the current account. According to conventional economic theory, opening up to 72

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foreign capital inflow should lead to higher economic growth. It adds foreigners’ savings to domestic saving, and it lowers the cost of capital by spreading the risks. It should lead to the inward transfer of new technology and it should help develop the country’s financial sector. Indirectly, it should make it easier for the country to specialise in what it’s best at and should put pressure on its government to manage the economy better. All these theoretical advantages, no doubt, were what prompted the IMF to be such an insistent urger of opening up to capital flows. But when Dr Rogoff checked to see what empirical evidence there was to support the theory, the discovery he made was ‘sobering’. ‘An objective reading of the vast research effort to date suggests that there is no strong, robust and uniform support for the theoretical argument that financial globalisation per se delivers a higher rate of economic growth’, the report admits sadly. Now, be clear on what this means. It’s not saying that the developing countries that have become more financially open over the past 20 years haven’t enjoyed faster economic growth. They have. (As everyone living in our region of the world should be in no doubt about.) It’s saying there’s no proof that financial openness contributed to that faster growth (whereas there is evidence that increased trade causes faster growth). Another qualification worth noting is that foreign capital inflow comes in various forms. One is ‘foreign direct investment’—multinational companies investing in factories and such like—whereas others include purchases of shares on the local stock exchange and short-term loans from foreign banks. The point is, once FDI comes in it can’t easily go back out, whereas the rest is highly volatile ‘hot money’. And there is evidence that FDI promotes economic growth. Economic theory also suggests that greater financial integration (between your financial markets and everyone else’s) should reduce an economy’s volatility. (This, for instance, is why so many economists said we benefited from having a floating exchange rate during

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the Asian crisis. The dollar fell right on cue, lowering the cost of our exports to foreigners just as we were having to find new buyers, thus acting as a kind of shock-absorber for the domestic economy.) But Dr Rogoff couldn’t find evidence for this in the developing economies. In fact, he found the opposite. ‘The evidence suggests that, instead, countries that are in the early stages of financial integration have been exposed to significant risks in terms of higher volatility of both output and consumption’, the report admits. Acknowledging ‘the proliferation of financial and currency crises among developing economies’, the report further concedes that there is empirical evidence to support a host of common criticisms of the global financial markets. ‘First, international investors have a tendency to engage in momentum trading [buying shares because they’re going up; selling shares because they’re going down] and herding, which can be destabilising for developing countries. ‘Second, international investors may (together with domestic residents) engage in speculative attacks on developing countries’ currencies, thereby causing instability that is not warranted based on the economic and policy fundamentals of these countries. ‘Third, the risk of contagion [being tarred with the same brush as a neighbouring country] presents a major threat to otherwise healthy countries since international investors could withdraw capital from these countries for reasons unrelated to domestic factors’, the report belatedly admits. When countries encounter external crises, the standard diagnosis of the IMF types is that they obviously brought it on themselves by their own macroeconomic mismanagement. In the case of the Asian countries, this wasn’t true or fair. So then people added the charge of ‘crony capitalism’—people in government doing deals with friends and relations in business—which was true enough, but shouldn’t have come as a surprise to any foreign investor with half a brain.

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No, it soon became apparent to the less ideologically blinkered that the Asian economies’ real trouble was their absolute lack of the well-developed, robust institutional arrangements in their financial markets that the developed countries have long had and which allow the rich economies to weather the volatility of global hot money flows without falling over. It was a typical failing of economists mesmerised by the narrow neo-classical model to be oblivious to the key role played by institutions when urging developing economies to do dangerous things for which they were woefully under-equipped. Guess what? The IMF has now discovered the importance of institutions. ‘The analysis suggests that financial globalisation should be approached cautiously and with good institutions and macroeconomic frameworks viewed as preconditions’, we’re told. ‘A growing body of evidence suggests that [the quality of domestic institutions] has a quantitatively important impact on a country’s ability to attract foreign direct investment, and on its vulnerability to crises. There is accumulating evidence of the benefits of robust legal and [prudential] supervisory frameworks, low levels of corruption, a high degree of transparency and good corporate governance.’ Unfortunately, however, the evidence doesn’t provide a clear road map for the ‘optimal pace and sequencing’ of integration. ‘For instance, there is an unresolved tension between having good institutions in place before capital market liberalisation and the notion that such liberalisation in itself can help import best practices and provide an impetus to improved institutions. Furthermore, neither theory nor empirical evidence has provided clear-cut general answers to related issues such as the desirability and efficacy of selective capital controls. Ultimately, these questions can be addressed only in the context of country-specific circumstances and institutional features’, the report concludes. Well blow me down. The IMF has now abandoned its fatwa

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against the unmitigated evil of capital controls. Institutional confessions of error don’t come much bigger than this one. But while the IMF’s many critics are rubbing it in, they shouldn’t forget that such a burst of intellectual honesty takes a lot of guts.

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chapter 15

THE WORLD TRADE ORGANISATION’S DOHA ROUND

The opponents of globalisation had a big setback at the World Trade Organisation’s meeting at Doha, Qatar, in November 2001. But while you’re shedding a tear, don’t forget that the poor countries of the world had a big win. As you recall, the vociferous protesters against globalisation first came to our attention when they disrupted the WTO’s meeting at Seattle in 1999. It’d been hoped that that meeting would agree to launch a new round of multilateral trade negotiations, but it collapsed in disarray. Don’t imagine, however, it was the protesters who did the damage. No, the problem was inside the meeting, where the developed and developing countries couldn’t agree on an agenda for the negotiations. A lot of people thought that failure might be the end of the matter. The WTO—successor to GATT, the General Agreement on Tariffs and Trade—had managed to organise eight rounds of multilateral reductions in protection since its formation in 1947 (Table 15.1), but it wouldn’t manage another. The member countries gave it one more try in 2001, however— this time taking care to hold their deliberations in the tiny Gulf state of Qatar, about as far away from disrupting demonstrators as they could get. For much of the time it didn’t look terribly hopeful 77

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Table 15.1 The nine multilateral rounds of tariff reductions under GATT/WTO 1. 2. 3. 4. 5. 6.

Geneva round, 1948: 23 countries; GATT enters into force. Annecy round, 1949: 13 countries. Torquay round, 1951: 38 countries. Fourth round, 1956: 26 countries. Dillon round, 1962: 26 countries. Kennedy round, 1967: 62 countries; across-the-board tariff reductions. 7. Tokyo round, 1979: 102 countries; reductions in non-tariff barriers. 8. Uruguay round, 1993: 123 countries; created WTO; agreement extended to agriculture, intellectual property and services. 9. Doha round, commenced in 2001; about 150 countries. Source: <www.absoluteastronomy.com>

and the meeting had to be extended to break the deadlock, but finally they pulled it off. The ninth round of multilateral trade negotiations—to be called the Doha round—will go ahead. Is it in the bag? No. It will obviously take a lot longer to complete than the three years originally allowed, and its death will be pronounced many times. It was just the same with the previous, Uruguay round—they had trouble getting it started in 1986 and it wasn’t completed until December 1993. But I don’t doubt, no matter how long this new round takes, it will be brought to a successful conclusion. Why so sure? Because the WTO has a secret weapon up its sleeve. That’s to say, it’s a secret to the opponents of globalisation, but well understood by the members of the WTO (as it is by the least advanced student of economics): the gains from trade are mutual.

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Some games in life are ‘zero-sum’: if I win, you must lose. But trade—whether it occurs between countries or within the same country—is a positive-sum, win–win game. With a willing seller and a willing buyer, both are better off. They wouldn’t do the deal if they weren’t. So, no matter how much they wrangle, it’s a safe bet the members of the WTO will eventually agree to further reduce the barriers to trade between them because they want to enjoy the greater affluence they know increased trade will bring. If you doubt that, look at the way countries have been queuing to join the WTO. In 1994 it had 122 members; now it has about 150. And 80 per cent of them are developing countries. Two new members were admitted at the meeting in Doha: China and Taiwan. China’s been busting a gut to join for years. Think of it—virtually the last remaining communist country, desperate to join the capitalist trading club. It had to pay a high price to join: conformity with WTO rules will cause great disruption to its more protected, inefficient industries. As an act of microeconomic reform, China’s joining the WTO makes our GST look like a teddy bears’ picnic. But, obviously, the comrades are convinced the benefits will exceed the costs. And consider this: because China is arguably the second-largest economy in the world—with a fifth of the world’s population—just the fact that it’s joined the WTO strikes a huge blow for increased globalisation. But to say the gains from trade are mutual isn’t to say they’re shared fairly between countries. I regret to say that the considerable gains from the WTO’s efforts to promote trade over the past 50 years have gone disproportionately to the developed countries. That’s because the first seven of its eight rounds focused exclusively on reducing trade barriers that happened to be politically convenient for the rich countries: those affecting industrial goods. Trade in agriculture was specifically excluded and trade in clothing and textiles was given a special exemption under the ‘multifibre arrangement’ (while trade in services wasn’t really thought of ).

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This meant the WTO’s efforts led to huge growth in trade in manufactures between the rich countries—thus helping to make them a lot richer—but did little to increase trade between the rich and poor because the rich countries maintained their high barriers against the main things the poor countries had to sell them: agricultural goods and labour-intensive textiles and clothing. The first move to broaden the WTO’s scope and make it more relevant to the interests of the poor countries came in the Uruguay round—partly at the urging of a strange developed country that, in some respects, has more in common with the developing countries. That country put together a lobby group of low-protection, agricultural exporting countries called the Cairns Group. (No prize for guessing the strange country.) The Uruguay round gave the Americans two things they desperately wanted: extension of the WTO’s realm into services (the general agreement on trade in services, or GATS) and the ‘traderelated aspects of intellectual property’ (or TRIPS). In return, however, it gave the developing countries two things they wanted: extension to trade in agricultural goods and the return of textiles and clothing to the fold with the phase-out of the multifibre arrangement. So Uruguay represented the first move to include the developing countries as full participating members of the trading club (which explains why so many of them have been joining up). But Doha—and the stalemate at Seattle—represents the poor members of the WTO coming into their own. What happened at Doha was that shifting coalitions of developing countries ganged up on the guys who’ve hitherto called the shots at WTO meetings—the Americans and the Europeans. The poor’s biggest win (against the bitter opposition of the European Union) was the agreement to negotiate extensive reductions in agricultural protection, including phasing out rural export subsidies. The negotiations will also cover hastening the phase-out of protection for clothing and textiles. Another big win for the poor

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was the declaration clarifying a provision of TRIPS which permits developing countries to gain access to cheap patent drugs needed to deal with pandemics such as HIV/AIDS, tuberculosis, malaria and sleeping sickness. What the Europeans wanted in return was to have trade agreements made subject to conditions about labour standards and environmental labelling standards. The poor countries vigorously opposed this, suspecting that such standards would be used as disguised protection. (The rich countries hypocritical? Never!) They managed to kill off the labour standards bit, while consideration of the environmental bit has been pushed off into the future. Now that the developing countries are using their numbers to mould the global trading rules to their interests, it will be interesting to see if the protesters and others who know what’s best for the poor moderate their criticism.

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chapter 16

TRANSNATIONAL CORPORATIONS’ SIZE IS EXAGGERATED

The big bad boogiemen of the globalised world are the Transnational Corporations. We’re told they’re growing bigger and more powerful as each year passes. Did you know that, of the 100 largest economies in the world, only 49 are countries? The other 51 are corporations. According to the outfit that computed this amazing fact, the Institute for Policy Studies in Washington, these comparisons will put it into perspective for you: General Motors is now bigger than Denmark, DaimlerChrysler is bigger than Poland, Royal Dutch/Shell is bigger than Venezuela, and IBM is bigger than Singapore. And if that doesn’t shock you, try this from the widely quoted Human Development Report of 1999: the three richest people in the world—Bill Gates and Paul Allen of Microsoft and the legendary American investor Warren Buffett—are worth more than the poorest 43 nations combined. Impressed? Don’t be. Both sets of comparisons—between countries and companies; rich men and poor nations—are invalid. They compare apples with oranges and, in the process, give you a quite exaggerated impression of the size of the world’s biggest companies (which, no doubt, is just what the shonks who put them together intended them to do). The dishonesty of the countries-versus82

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companies comparison is exposed in a 2002 paper, ‘How Big are the Big Multinational Companies?’, by Paul De Grauwe of the University of Leuven in Belgium and Filip Camerman of the Belgian Senate. The trouble is that, whereas the size of countries is represented by their GDP, as you’d expect, the size of companies is represented by their total sales (turnover). The two are far from the same thing. Gross domestic product represents the total value of all the goods and services produced by a country during a period. But you don’t calculate that value by adding up the sales of all the companies and other businesses in the country. If you did, you’d get a hugely inflated figure for GDP. Why? Because a lot of the sales companies make are to other companies. Remember that the process of producing and distributing goods forms a chain: farmers and miners sell raw materials to manufacturers, manufacturers sell to wholesalers, wholesalers sell to retailers and retailers sell to you and me. So if you merely added together the sales at every stage, you wouldn’t get double counting so much as quintuple counting. No, the way you work out GDP is to calculate the ‘value added’ at each stage and add that together. The value a firm adds to the goods (or services) it sells is its sales minus the cost of all the materials and services it had to buy from other firms. You get the same answer if you add together the remuneration paid to the labour (wages, etc.) and capital (interest and profits) employed by the firm. (If all this is sounding vaguely familiar, that’s because it’s the same way a firm works out how much GST it has to pay. GST is, after all, a tax on ‘value added’.) To permit a valid size comparison between companies and countries, our Belgian mates use the companies’ published financial accounts to convert their sales into their value added. And, boy, doesn’t that cut ’em down to size. Using figures for 2000, General Motors had sales of $US185 billion ($A321 billion), but value added of only $US42 billion. Ford went from 170 to 47, and

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British Petroleum from 148 to 34. It turns out that, for the big multinational service companies, value added averages only about 35 per cent of sales. For the big industrial companies, it averages only 25 per cent. Now, when we rework our league table using the companies’ value added, we find that the number of companies making it to the top 100 ‘economies’ falls from 51 to 37. And only two of those companies—Wal-Mart and Exxon—make it into the top 50. But that still exaggerates the relative size of the companies. Try this: the US economy is 200 times bigger than the biggest corporation; Japan is 100 times bigger and China 20 times. Putting it all together, the combined value added of the 50 biggest corporations represents only 4.5 per cent of the GDP of the 50 biggest countries. As for all those particular companies, General Motors, DaimlerChrysler, Shell and IBM each are only a third to a quarter the size of Denmark, Poland, Venezuela and Singapore, respectively. Turning to the riches of the billionaires who own large chunks of the big multinationals, Ian Castles, a former head of the Australian Bureau of Statistics, has pointed out that it’s invalid to compare the wealth of individuals (which is the value of a stock of assets at a point in time) with the GDP of countries (which is a flow of income over a period of time). For the most part, the billionaires’ wealth would represent the market value of their shares. The value of a share is supposed to be the market’s estimate of the present value of all the earnings likely to flow to the owner over the rest of the company’s life. So one way to try to compare like with like would be to ask how many years’ worth of GDP the billionaire could afford to buy with all his wealth. And Mr Castles estimates that if the 200 wealthiest individuals and families in the world spent every penny of their wealth, they could afford to buy just ten days’ worth of the world’s production of goods and services.

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In May 2000, when Forbes magazine put Bill Gates’s wealth at $US60 billion ($A105 billion), he could have afforded to buy just half a day’s worth of the world’s production of goods and services. If he limited himself to buying only America’s GDP, he could have afforded a bit over two days’ worth. And if you think Our Bill must surely be the richest man who ever lived, think again. At the height of the stockmarket in 1913, the Rockefeller fortune would have bought about eight days’ worth of US GDP. When the opponents of ‘corporate globalisation’ try to impress us with their shonky comparisons, they often imply or even assert that the big multinationals are a lot bigger than they used to be. That’s true only in the sense that most things in the economy are bigger than they used to be. Our Belgian mates demonstrate that, since 1980, the top 50 multinationals haven’t grown as fast as world GDP. Have they become more powerful? Power’s a dashed hard thing to measure, but there’s little evidence to say they have. One (imperfect) measure of economic power—the power to overcharge—is the ‘concentration index’: the change in the combined market share of, say, the four biggest companies in a particular market. There’s no evidence of a general increase in concentration. It’s up in some global markets (such as software), but down in others (telecommunications). As for political power, one indication of a multinational’s power is whether it can stay big. But roughly half the corporations that were in the top ten, top 20 and top 50 in 1980 aren’t there today. Enron must surely be the classic case. It had a lot of political power in 2001, but has none today. So before you buy the line that multinationals are now so big they’re pushing around the governments they dwarf, take a careful look at the gee-whiz facts and figures in the sales pitch.

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chapter 17

THE RISE OF CHINA

If you want to know the future, I can give it to you in one word: China. In our lifetime we’re witnessing the emergence of a new economic superpower to rival America: China. But unlike the power it’s in the process of eclipsing—Japan—China will also be a political superpower. It won’t surprise you that China is the biggest country in the world. Its 1.3 billion people account for a fifth of the globe’s population. What may surprise you is that China has the fastest-growing economy in the world. China’s economy doubled in size in the 1980s, then doubled again in the 1990s. And in 2002 we had a report from the Department of Foreign Affairs and Trade’s Economic Analytical Unit, China Embraces the World Economy, predicting that China will achieve a growth rate averaging 7 per cent a year in the present decade. If so, its economy will double yet again. But can we believe these amazing figures? The report has checked with the international experts and says, yes, they’re near enough. What all this growth means is that, if you allow for the fact that one US dollar purchases a lot more in China than it does in Japan, China’s economy is already the second biggest in the world, and already about two-thirds bigger than Japan’s. Unless it’s knocked off 86

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its present trajectory, it should overtake America in size some time in the 2020s. A key element in China’s economic success story is the sleeping giant’s decision for the first time in centuries to open up to the rest of the world. Like so many Asian countries before it, it’s been pursuing a strategy of export-oriented growth. So China’s exports and imports have been growing even faster than its economy, to the point where, in combination, they now account for 80 per cent of its GDP (compared with about 40 per cent in Australia). China doesn’t yet have the dominance in world trade that its size would suggest. But just give it time and consider its rate of advance. In 1990 it was the world’s fifteenth-biggest trading nation; now it’s the third. In December 2001—after years of preparation on the part of the Chinese, and years of hesitation on the part of the Americans— China was admitted to the World Trade Organisation. That gives it entree to the world’s domestic markets on the same basis as every other WTO member. But the WTO is all about reciprocity, so the Chinese have been obliged to open up their market as never before. In 1992, China’s average rate of duty on imported goods was 43 per cent. Now it’s 10 per cent. The point is that China’s long-sought admission to the global trading club will be a further boost to its economy. The new report estimates that it will add 1 percentage point a year to China’s potential rate of economic growth over this decade. China’s economic growth is being led by the expansion of its private or foreign-owned manufacturing sector. Since 1990, the share of its economy accounted for by agriculture has fallen from 27 per cent to 15 per cent, whereas the share represented by industrial production (most of which is manufacturing) has risen from 42 per cent to 53 per cent. And get this: manufactured goods account for 93 per cent of China’s exports. Those exports are dominated by simpler, labourintensive goods such as clothing, footwear, toys, sporting and travel

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goods (or, as my family of Queenslanders would say, ‘ports’). Increasingly, however, it’s exporting more valuable goods—household electrical items, including airconditioners, televisions and washing machines. And it now accounts for more than a quarter of global computer and office machine exports (though many of these are assembled from imported components). Where is the capital and know-how coming from to make all this possible? From huge investment by foreign multinationals. For some years, China has been the world’s second largest recipient of foreign direct investment, taking the lion’s share of all the investment flowing to developing countries. In 2004 it overtook the United States with a record $US58 billion inflow. As the report explains, ‘many multinational manufacturers of higher-value products—including JVC, LG, Panasonic, Sony and Samsung— are shifting a significant part of their production to China and exporting from there’. So here is the phenomenon that’s putting China at the front of the minds of businesspeople, politicians and economists around the world: it seems we’re observing a significant proportion of the entire globe’s production of manufactured goods in the process of shifting to China. It also seems that this process is at the heart of the explanation for another remarkable phenomenon: for some years now, the prices of many manufactured goods around the world have been falling, not rising. If all that sounds a bit disturbing, let me first make the point that ordinary Chinese workers are getting their cut from all this growth. Among China’s rural population, ownership of refrigerators has risen from one per 100 households in 1990 to one per six households in 2003. Ownership of washing machines has gone from 9 to 34 per cent of households, and ownership of colour televisions has gone from 5 to 68 per cent. In urban areas, the rise in affluence has been even more spectacular. As for us, economically we have everything to gain and little to

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14 12

Imports Exports

Per cent

10 8 6 4 2 0

89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 Year

Figure 17.1 China’s share of Australian exports and imports Source: ABS

lose from China’s rise as a global manufacturing powerhouse. For a start, we’ve already bitten the bullet on the reform of our labourintensive manufacturing industries and, more positively, our economic strengths are a good complement to China’s. Since 1998 alone, our exports to China have quadrupled (Figure 17.1). The more manufactures they export, the more iron ore, wool, LPG, alumina and other metals they need to import from us. The number of Chinese students in Australia tripled between 1998 and 2000, reaching almost 70 000 in 2004 and making China our No. 1 source of full-fee-paying students. And since 1995, the number of Chinese tourists has grown from 42 000 a year to more than 250 000. China’s rocket-like growth has a long way to go yet, and we’re sitting pretty.

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par t VI

AUSTRALIA’S PLACE IN THE GLOBAL ECONOMY

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chapter 18

COMPOSITION AND DIRECTION OF OUR EXPORTS

If you want to see how much globalisation has changed our economy over the past two decades, have a look at our exports. There have been big changes in what we export and who we sell it to. Most people are conscious that, since we began opening up our economy to the world in the mid-1980s, we’ve been importing a lot more stuff. Walk into a supermarket—or just the car park—and you see it staring at you. But while we can see how much we import, we can’t see how much we export—it’s sitting in other countries’ supermarkets and car parks. In fact, however, we’re exporting a lot more than we did. Exports of goods and services now account for about 18 per cent of gross domestic product(ion), up from 16 per cent in the mid-1980s. They actually got up to 23 per cent in 2000, but they fell back during the years of our great housing boom. With any luck they’ll start growing strongly again. Another thing that’s not visible to the naked eye is the changed ‘composition’ of what we export. It will surprise many people that our exports of manufactures have expanded considerably since we began dismantling protection against imports, so that they now account for almost a quarter of our total exports of goods and 93

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services. What’s more, about 70 per cent of our manufactured exports are ‘elaborately transformed’, as opposed to ‘simply transformed’. That is, they’re more sophisticated items, with more value added. Exports of services—mainly inbound tourism, education and business and professional services—have also grown strongly over the past 20 years or so, so that they too now account for almost a quarter of total exports. But rural exports haven’t grown all that strongly, and their share of total exports has dropped markedly, from almost a third to just over a fifth. Successive droughts haven’t helped and nor have weak world prices for agricultural goods. Minerals and fuels are still the mainstay of our export performance but, even so, their share of total exports has slipped to a third. So whereas people—here and abroad—have always seen us as a country whose exports were dominated by rural and mineral commodities, that’s less true than it used to be. Since the mid1980s, their share of total exports has fallen from two-thirds to just over half. But as the composition of our exports has changed, so too has their ‘direction’—the countries we send them to. No prize for knowing that, over the past two decades, we’ve been exporting a lot more to North-East and South-East Asia, which now accounts for almost half our exports of goods and services. But as well as Asia’s share as a whole expanding, there’ve been big changes in which countries within Asia are taking it. For instance, while Japan remains our biggest single export destination, its share has fallen continuously since 1985/86, dropping from 25 to 16 per cent. And while Japan’s share has been falling, China has been rising to take its place. Its share since 1985/86 has gone from 4 per cent to 8 per cent—with a lot more to come. Many economists expect that China will before long overtake Japan as our biggest trading partner. Our major exports to China are (in order) oil and gas, iron ore, wool, coal and aluminium.

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Table 18.1 How our exports are changing What we sell Rural Minerals and fuels Manufactures Services Total Who we sell to Rest of developing Asia Japan Europe United States China New Zealand Rest of world Total

1985/86 (%) 31 36 15 18 100 1985/86 (%) 16 25 16 12 4 6 21 100

2003/04 (%) 21 32 23 24 100 2003/04 (%) 24 16 15 10 8 7 20 100

Source: DFAT

That leaves exports to the rest of developing Asia—including Korea, Taiwan, Hong Kong and countries within the Association of South-East Asian Nations (ASEAN)—having risen from 16 per cent to 24 per cent. Did you know that, in total, Europe’s share of our exports has always been quite a lot bigger than America’s? It’s true, and over almost the past 20 years both shares have declined as developing Asia’s share has increased. Europe’s share has gone from 16 per cent to 15, while America’s has gone from 12 per cent to 10. The much-trumpeted preferential trade agreement with the United States isn’t likely to change that a lot. With the Closer Economic Relations agreement and a common labour market, New Zealand is almost part of our economy. So, not surprisingly, that small country of four million people takes a disproportionate share of our exports: 7 per cent, up from 6 per cent in the mid-1980s.

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That leaves all the other countries of the world—including those in the Middle East, Africa and South America—accounting for just 20 per cent of our exports, down from 21 per cent in the mid1980s. To date, we’ve tended to lump South Asia in with ‘rest of the world’ rather than with rapidly developing Asia. But this may need to change. In 1985/86, India’s share of our exports was just 1 per cent. Today it’s nearer 4 per cent. Our major exports to India are gold (way out in front), coal, copper and wool. You see that our exports to the two most populous and fastgrowing economies in the world—China and India—are dominated by minerals and fuels, with a bit of wool thrown in for good measure. So while we can be pleased that the growth in our exports of manufactures and services has diminished our reliance on commodity exports, it turns out that, with China and India needing to suck in huge quantities of raw materials as they rapidly tread the road from developing to developed, we can expect minerals and fuels to reassert itself as our fastest growing export category.

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chapter 19

AUSTRALIA’S GROWING INVESTMENT ABROAD

Did you know that, over the 15 years to 2002, the proportion of our superannuation money that’s invested overseas doubled to almost 30 per cent? And did you realise that, over the same period, Australian companies were spending the equivalent of about $7 billion a year to buy or set up businesses in other countries? A lot of people who have heard tell of these things aren’t too happy about them. How can that be good for our country? How can we afford to be investing in other people’s economies? Surely that money would be much better employed generating jobs and income back where it belongs in Oz. And what’s this great outflow of funds likely to do to the value of our dollar (if it hasn’t already)? Is the poor old battered Aussie ever going to pick itself up off the canvas, or is it doomed to keep weakening as the cash keeps leaving? In short, how worried should we be? Well, according to an assistant governor of the Reserve Bank, Ric Battellino, in a speech he gave in 2002, not very. We’re just witnessing some of the as-yet unfamiliar effects of globalisation. And, as with various (but not all) aspects of globalisation, they’re not as bad as they first appear. Let’s start with all that super money being invested overseas. Why’s it happening? It’s happening in accordance with one of the 97

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most basic rules of investment: diversification. To minimise the risk of loss, don’t keep all your money in one basket, but spread it around. You need to spread it between shares, fixed interest and property, etc., but also spread it between countries. The idea is that they won’t all be doing badly at the same time; while some are down, others will be up. Mr Battellino says we shouldn’t get too carried away by super. Super funds account for only part of all the money we have in managed investment funds. And when you cast your gaze even wider to the nation’s total portfolio investment abroad each year, you’ll find it hasn’t changed much for a decade, staying fairly steady at about 1.5 per cent of GDP a year. What this means is that, since the super funds have been increasing the amount they send abroad each year, other investors must have been doing the opposite. Some people have convinced themselves that, with more money going into compulsory super every year, the amount of funds going abroad will just keep growing. But Mr Battellino says there’ll be a natural limit to the funds’ offshore investment. At present, the 30 per cent of their total assets they have abroad is composed of 5 percentage points in foreign bonds and 25 points in foreign shares (‘equities’). The bonds are largely ‘hedged’ (the funds have insured themselves against the possibility of loss from changes in our exchange rate), but the shares are largely unhedged. It’s the shares that have been increasing, so the super funds have become increasingly exposed to foreign-exchange loss should our dollar go back up. ‘There will come a point where superannuation fund trustees will resist further increases in their exposure to exchange rate fluctuations, and direct their funds managers either to stop increasing the allocation to offshore equities or, more likely, to invest on a hedged basis,’ Mr Battellino says. ‘I would not be surprised if we were already reaching such a point.’ The other thing to remember is that this kind of international diversification of investment funds is happening in other countries,

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too (for just the same reason). So while we’re buying other people’s shares, they’re buying ours. Some people worry that, because Australia is only a small country, we won’t be ‘on the radar screen’ of overseas fund managers. But that argument cuts both ways: because we’re small relative to the rest of the world, we need to attract only a tiny proportion of the world’s huge capital flows to get as much as we need. And the simple fact is that, with the notable exception of 2000, we’ve had little trouble attracting a healthy inflow of foreign investment in Australian shares. So much so that, apart from 2000, the inflow of share investment money has usually comfortably exceeded the outflow of share investment money. (It does seem likely, however, that the virtual absence of foreigners’ purchases of our shares in 2000, combined with our heavy purchases of theirs, goes a long way towards explaining the big slide in the Aussie dollar that year. It was the year of all the silliness about us being an Old Economy.) So far, we’ve been talking about ‘portfolio investment’—the purchase of shares or bonds. But now we turn to ‘direct investment’—the purchase or establishment of whole businesses (or, at least, a controlling interest in them). In the 15 years to 2002, the amount Australian companies have been investing each year in overseas businesses has more than doubled to the equivalent of about 1 per cent of GDP (which in 2002 meant roughly $7 billion). A study by the Department of Foreign Affairs and Trade has found that 20 of our big companies account for the lion’s share of this outflow. In June 2000, their foreign investments averaged 35 per cent of the value of their total assets, up from 30 per cent five years earlier. For companies at the top of the list, however, the proportion of their assets held abroad was much higher. Here’s a taste: News Corp., 89 per cent; QBE, 76; Brambles, 69; Pioneer, 62; AMP, 61; Rio Tinto, 60; Coca-Cola Amatil, 59; Lend Lease, 57; and Pacific Dunlop, 53 per cent.

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Two government studies have concluded that, on balance, foreign investment by Australian companies is a good thing for the economy. As well as the profits flowing back to us, there are positive spin-offs for the companies’ local operations. In most cases, companies undertook offshore investment because they had developed strong skills and expertise within their particular fields, which they could profitably take overseas. Negative reasons for moving operations overseas—that is, because there was something wrong with the Australian business environment—seemed to be in a minority. But if that doesn’t satisfy you, remember this: we have more foreign direct investment money coming into Australia than we have Aussie money going out to buy foreign businesses. And note that what our companies are doing is being done in all the big industrial countries (bar Japan). Over the course of the 1990s, the value of the stock of overseas assets owned by our companies doubled to about 25 per cent of GDP. Pretty much the same can be said of Germany, the United States, Canada and Britain (though Britain’s assets leapt to 64 per cent of GDP). Mr Battellino observes that ‘while we are often tempted to try to explain these trends in terms of factors specific to Australia, the fact is that the same trends are apparent in virtually all industrial countries. The widespread trend towards increased offshore investment seems to reflect the globalisation of economies and capital markets, rather than developments specific to any particular country.’ In other words, in a globalised economy, everyone invests in everyone else’s backyard and it all gets increasingly mixed up.

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chapter 20

WHY INDUSTRY PROTECTION DOESN’T WORK

How much industry assistance—or, if you prefer, ‘business welfare’—does the federal government provide in these days of globalisation and deregulated markets? More than you may think. One of the Productivity Commission’s jobs is to conduct an annual review of assistance to industry. And its report for 2003/04 makes illuminating reading. The PC found that the value of all the main forms of industry assistance totalled almost $12 billion a year, with the lion’s share of that still coming from tariff protection. When governments slap tariffs (import duties) on certain imported goods, they benefit the local producers of those goods by permitting them to charge higher prices than they would otherwise be able to. The value of tariff assistance provided to Australian industries— almost exclusively manufacturing industries—is very much less than it used to be because of the extensive reductions initiated by the former Labor government during the late 1980s and the 1990s (Figure 20.1). Even so, the PC estimates tariff assistance is still worth $7.5 billion a year. Rates of duty are now 5 per cent or less for all parts of manufacturing bar two. 101

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40 35

Per cent

30 25 20 15 10 5 0 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000

Year

Figure 20.1

Rate of tariff protection in the manufacturing sector

Source: Productivity Commission

Since January 2005, the duty on motor vehicles and parts has been 10 per cent. It’s intended to fall to 5 per cent in January 2010. The other remaining island of protection is the textiles, clothing and footwear (TCF) sector. Its duty rates since January 2005 have been 17.5, 10 or 7.5 per cent. These will fall to 10 or 5 per cent in January 2010. If you take the net value of the assistance provided to an industry and express it as a proportion of the value added by that industry (which is the value of its output less the value of inputs coming from other industries) you get its ‘effective rate of assistance’ (ERA). And whereas the ERAs for other parts of manufacturing are less than 5 per cent, for textiles, clothing and footwear it’s 24 per cent. In other words, for every $4 the sector generates under its own steam, the government obliges the rest of us to give it almost another $1. For motor vehicles and parts, the effective rate of assistance is 11 per cent. But tariff protection is only one form of government assistance to industry. Another $4.3 billion a year comes direct from the federal budget, divided about equally between government

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spending and special tax breaks (‘tax expenditures’ as they’re called). Actual budget spending goes on such things as funding the CSIRO, Austrade and the Australian Tourist Commission, and direct grants to the pharmaceuticals industry and the TCF sector. The main tax concessions are for the motor vehicle industry, research and development spending and income tax averaging for farmers. If you divide the total budgetary assistance up by industry, getting on for half goes to manufacturing, a quarter to farmers, a fifth to the services sector and less than a twentieth to mining. Historically, most assistance to farmers has been in the form of statutory marketing arrangements intended to keep the prices they receive higher than otherwise. But most of these schemes have been dismantled over recent decades. By now, the only significant federal pricing and regulatory assistance is going to dairy farmers ($150 million, down from $450 million in 1999/2000), sugar growers ($8 million) and rice growers ($6 million). OK, that’s a quick update on how much tariff protection and other industry assistance is still being provided. But what of it? Why denigrate it with talk such as ‘welfare for businesses’? All the industries receiving assistance are creating jobs for Australian workers and all would assure us that, were their assistance to be reduced or removed, they’d be obliged to sack lots of people. And it’s true, they would—though probably to a much lesser extent than they’d claim if their assistance were under threat. (They never admit it, but a fair bit of the assistance props up their profit, not their payroll.) So why be down on business welfare? Because, when it comes to industry assistance, the old saying is right: there’s no such thing as a free feed. As the PC explains in its report, ‘although assistance generally benefits the firms or industries that receive it, it comes at a cost to other sectors of the economy’. Take protection. The tariff that allows a local industry to charge a higher price for its product (and thus employ more people than

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otherwise) raises the costs of other local industries that use the product as an input to their own production. It also means higher prices for consumers, who then have less money left to spend on other locally made goods and services. Or, take budgetary assistance. The particular firms or industries obviously benefit when governments give them money or tax concessions or provide them with free services. But to fund those subsidies, governments must increase taxes and charges, cut back on other spending, or borrow additional funds. Make a note of this: the great catch to protection and other industry assistance is that you can only protect jobs in industry A at the expense of jobs in industries B to Z. The PC has done some figuring to demonstrate that dismal truth. It estimates that the total $7.5 billion in tariff assistance provided mainly to manufacturing industries in 2003/04 also raised the cost of the inputs used by farmers by $95 million and those used by miners by $170 million. It raised the cost of the inputs used by industries in the services sector (the sector that’s our most labour intensive) by $2.8 billion. But get this: it raised the cost of inputs used by manufacturing industries by an amazing $2.5 billion. So the gross tariff assistance provided to manufacturers of $7.4 billion was immediately reduced to $4.9 billion, simply because a third of the burden of protecting employment in manufacturing was actually borne by manufacturers themselves. And that’s not counting the indirect effect of all the sales the manufacturers didn’t make because consumers were paying more than they could have been for all the services they buy. Protection is a three-card trick. That’s why we’ve cut it back so much and still need to keep a close eye on how much business welfare our pollies are doling out to their industry mates.

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chapter 21

HOW GLOBALISATION AFFECTS OUR ECONOMY

The globalisation of the world economy—and our response during the 1980s in opening up our economy to the world—has had many effects on us, some of them obvious, some of them less so. Among the obvious effects are the increase in our ‘trade intensity’—imports have risen to 20 per cent of GDP while exports have risen to 18 per cent—and the changed composition and direction of our exports (see Chapter 18). But it’s also possible to identify at least seven newer or less obvious implications of globalisation for the way the economy works. The first is our changing terms of trade. The rapid industrialisation of China and its emergence as the next economic superpower is having a major effect on global trade. Its huge demand for imports of raw materials is pushing up the price of oil, coal and other forms of energy, as well as many minerals, including iron ore. Although there are bound to be cycles and hiccups, this seems likely to be a long-term trend with further to run, especially as India joins the game. On the other hand, China’s emergence as one of the globe’s greatest exporters of manufactured goods is exerting downward pressure on world prices of many manufactured items, with computers and computer components a standout example. 105

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140 Forecast

130

Per cent

120 110 100 90 80 79

82

85

88

91

94 Year

97

00

03

06

Figure 21.1 Australia’s terms of trade Source: ABS

Because Australia is a major exporter of minerals and energy, but a heavy importer of manufactures, this transforms the outlook for our terms of trade—the prices we receive for our exports relative to the prices we pay for our imports. It had long been imagined that our terms of trade were in long-term decline as world commodity prices kept falling and world manufactures prices kept rising. Instead, our terms of trade improved by more than 40 per cent over the seven years to 2005/06 to be at their highest in 50 years (Figure 21.1). The national accounts are constructed on the assumption that national income grows at the same rate as national production (GDP), but this assumes unchanged terms of trade. If our terms of trade are improving—meaning that the purchasing power of our exports has risen—this represents an increase in our real income over and above the growth in real GDP. The Statistician estimates that, over the year to December 2004, real gross domestic income grew by 3.5 per cent, compared with growth in real GDP of just 1.5 per cent. The point is that much of this extra income will be

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spent, entering the national accounts via increased domestic demand or gross national expenditure (GNE). The second less obvious implication of globalisation concerns the terms of trade and the exchange rate. Some people get confused between the two, imagining that a fall in the dollar improves our terms of trade. This is quite wrong. In principle, the terms of trade have nothing to do with the exchange rate. Terms of trade are really about changes in the world prices of exports and imports. Though it’s true that the export and import prices used to measure our terms of trade are expressed in Australian dollars, in simple principle a movement in the exchange rate should have the same effect on export prices as on import prices. However, particularly because the Australian dollar is regarded as a ‘commodity currency’, it is usual for a rise in world commodity prices to lead to an appreciation of the Aussie and for a fall in world commodity prices to lead to a depreciation. This is important because it affects exactly who it is that gains or loses from a change in the terms of trade. So the third implication concerns who gains income from improved terms of trade. Let’s start by assuming that an improvement in the terms of trade causes no change in the exchange rate. If the improvement is caused by a rise in world commodity prices, the real income gain to the nation will go to farmers and miners. If it’s caused by a fall in the world price of imports, however, the real income gain will go to importers and the final purchasers of imports—consumers and businesses buying imported capital equipment. But now let’s assume an improvement in the terms of trade leads to an appreciation in our dollar. This is most likely to happen where the improvement arises from higher world commodity prices. And when it does happen, it means the income gains to farmers and miners are cut back (their higher world prices don’t translate into as many Aussie dollars as they would have done) and shared with importers and the final purchasers of imports (the appreciation has lowered the Aussie-dollar price of imports). In the particular case

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we faced in the mid-2000s, the world price of manufactures had fallen and the dollar had appreciated, so importers got a double benefit. We would therefore expect a fair bit of the real income gain from the improvement in the terms of trade to be spent on imports. The fourth implication of globalisation concerns ‘the Dutch disease’. If our terms of trade are in a long-term improvement phase because of the rise of China and India’s demand for commodities, it’s reasonable to expect that, in coming years, our exchange rate is likely to be higher than otherwise. If so, that would be no worse for our farmers and miners than they have come to expect. It would be great for importers and the users of imports. But it would be bad news for our exporters of services, and particularly bad news for our exporters of manufactures. At a time when they were facing increased competition from China, the high exchange rate would make them less price competitive. This problem is known to economists as the Dutch disease because Holland faced a similar problem in the 1970s. The fifth implication of globalisation is that it has eased the ‘external constraint’. In the days of fixed exchange rates and the exchange controls needed to keep them fixed, it wasn’t possible for a country to run large current account deficits (CAD) because it was very difficult to finance them with capital inflow. If, because an economy was growing strongly, the CAD started growing beyond the rest of the world’s willingness to finance it, the country’s foreign exchange reserves would fall quickly and the country would enter a ‘balance of payments crisis’. The economy had hit its ‘external constraint’ and the government had no choice but to rein in growth by raising taxes, cutting government spending and raising interest rates. This would cut demand—including demand for imports— and reduce the CAD to a level foreigners were willing to finance, thus ending the run on exchange reserves and getting the economy back inside the external constraint. The point is, all this has changed with the move to floating exchange rates, the removal of exchange controls and the growing

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integration of the world’s financial markets. Because financial capital flows far more readily between countries, and because exchange rates fall automatically in response to any reluctance to finance CADs, the external constraint has become much less binding. That is, the economic managers don’t have to worry that rapid growth may lead to a balance of payments crisis, thus requiring them to jam on the fiscal and monetary brakes. The corollary is that it is now possible for CADs (and current account surpluses) to be higher for longer. Countries that have high saving rates but limited profitable investment opportunities (for example, Japan and Germany) will tend to run constant large surpluses, while countries with low saving rates but abundant investment opportunities (for example, Australia and the United States) will tend to run constant large deficits. When external imbalances started growing in the early 1980s, many economists believed they were unsustainable and would end in tears. But they were going by the old rules of the fixed exchange rate world. When time passed and disaster didn’t strike, they eventually realised that globalisation had changed the rules. Current account imbalances have now been large for 20 years and economists have become less worried. The sixth implication of globalisation is that it has made foreign debt less risky. If we run large CADs for a sustained period, the inevitable result is large net foreign liabilities, including net foreign debt. Initially, many economists believed this large debt left us vulnerable to a sudden loss of confidence by the world financial markets. If the value of our dollar fell sharply, this would greatly increase the Australian-dollar value of our debt and the cost of servicing that debt with interest payments. The particular businesses that had borrowed the money would now owe more than they could repay, and thus go bankrupt. This is exactly what happened to Thailand, Korea and Indonesia during the Asian financial crisis of 1997–98. They had no choice but to crunch their economies.

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But our own economic managers are now much less worried about something similar happening to us. Why? Because the previous analysis assumed that the foreign debt was borrowed in foreign currencies, usually US dollars. Over time, however, about 40 per cent of our foreign debt has been borrowed in Australian dollars (by foreigners purchasing $A government and corporate bonds), with almost all of the remainder (most of it borrowed by our banks) having been hedged back into Australian dollars. In other words, we have shed the foreign exchange risk to others. Were our dollar to fall precipitately, as it did in 2000–01, there would be little change in the value of our debt or debt service costs. The final, less obvious, implication of globalisation—in particular, the integration of our capital market with the world capital market—is that it has changed the crowding-out mechanism. The explanation of crowding out given in old textbooks is that expansionary fiscal policy means a higher budget deficit and thus increased government borrowing to finance the deficit. This increased demand for the supply of loanable funds forces up the level of interest rates. The higher interest rates will make some planned private investment projects no longer profitable, so they will be abandoned. Thus some private spending will have been crowded out by the increase in public spending. If the crowding out is ‘complete’, the increase in public spending will be exactly offset by the decrease in private spending. There will be no change in aggregate demand and so the government’s attempts to use fiscal policy to stimulate demand will be ineffective. But this explanation rests on an assumption that the supply of loanable funds is fixed by the amount that Australians save. If supply is fixed but demand increases, the price—interest rates— will rise. But though this assumption was realistic in the days before financial deregulation and our integration with the world capital market, it’s not realistic today. Today, a more realistic assumption is that financial capital is highly ‘mobile’ into and out of Australia.

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This means the supply of loanable funds isn’t limited to Australian saving. Rather, funds can be readily attracted from around the world. And an increase in our government’s demand for funds to finance its higher deficit would have little effect on the world demand for funds. Thus there is no reason to believe increased government borrowing will have much effect on the level of interest rates in Australia. But this doesn’t mean there will be no crowding out. Increased government borrowing will lead to increased foreign capital inflow. Increased inflow adds to the demand for Australian dollars and so pushes up the exchange rate. The higher exchange rate worsens the international competitiveness of our export and import-competing industries, eventually reducing the volume of exports and increasing the volume of imports. The mechanism now works via a rise in the exchange rate rather than a rise in interest rates. And the private sector activity that’s crowded out is the production of exports and import-competing goods rather than private investment. The moral of the story is that, as economic theory predicts, globalisation is changing the economies of all the countries that participate in it, and changing the way those economies work.

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par t VII

ECONOMIC ISSUES

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chapter 22

THE COMING SLOWDOWN IN ECONOMIC GROWTH

Since the publication of the Intergenerational Report in 2002, the nation’s been undergoing a crash course in the mysteries of demography and its implications for the economy. Not before time. If you think the public’s level of economic literacy is pretty low, its demographic literacy is lower. But not to worry. In one of several speeches that year, Peter Costello gave us a most useful lesson on the subject. He captured our attention by reminding us that demographic change—the ageing of the population, if you prefer—is likely to take a big bite out of future economic growth. Whereas over the past 40 years the economy—real GDP—grew at a rate averaging 3.75 per cent a year, the report projects that over the next 40, growth will slow to only 2.25 per cent a year. Mr Costello sought to explain, first, just how demographic factors are likely to bring the slowdown about and, second, what we can do to try to speed things up. This is neat: growth in GDP can be accounted for by what he calls ‘the law of the three Ps’—population, participation and productivity. Starting with population, it’s obvious that a larger population will produce a larger GDP. Over the past 40 years, population growth 115

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contributed an average of 1.5 percentage points a year to the growth of GDP. Over the coming 40, however, a lower birth rate caused by women’s declining rate of fertility is projected to see population growth’s contribution to GDP more than halved. A second part of the population story, however, is the extent to which the population of working age (that is, 15 and over) is growing faster than the population generally. Over the past 40 years, the maturation of the bulge of babies born in the first 15 years after World War II caused the working-age population to grow a lot faster. So much so that it added another 0.5 percentage points to annual GDP growth, taking population’s total contribution to 2 percentage points. Over the coming 40 years, however, the delayed effect of the steady decline in fertility since 1961 (after the arrival of the contraceptive pill ended the baby boom) means the over-15 population is projected to grow only a fraction faster than the population generally. So population may contribute only about 0.75 percentage points to annual GDP growth. Now on to ‘participation’. Mr Costello defines this broadly to cover more than just the usual change in the proportion of the working-age population choosing to participate in the labour force by working or actively seeking work. He also takes account of unemployment and changes in the average number of hours worked per week. Over the past 40 years, married women’s return to paid employment caused the participation rate to rise, but this was more than offset by the steady worsening in unemployment and the growth in part-time employment (which reduced average hours per worker). All told, these three participation factors made a negative contribution to growth of about 0.25 percentage points a year. Over the coming 40 years, unemployment is projected to be a lot lower and average hours per worker a fraction higher. But the baby boomers’ move into retirement will cause the participation rate to fall a long way. So, all told, the three participation factors may make another negative contribution of 0.25 percentage points a year.

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That brings us to ‘productivity’—the output produced by an average hour of work. The productivity of labour can be increased by ‘capital deepening’ (a man on a backhoe can dig more than a man with a shovel) or through other means (lumped together as ‘multi-factor’ productivity). Over the past 40 years, labour productivity contributed an average of 2 percentage points to annual GDP growth. Over the coming 40—well, who knows? But, because the past 40 years included very high rates of productivity improvement in both the 1960s and 1990s, the projection makes the cautious assumption that productivity will contribute an average of 1.75 percentage points a year between now and 2042. So, putting it all together, the sources of the 3.75 per cent average GDP growth over the past 40 years were: population, 2; participation, minus 0.25; productivity, 2. The sources of the projected average 2.25 per cent GDP growth over the coming 40 years are: population, 0.75; participation, minus 0.25; productivity, 1.75. This means that, of the projected 1.5 percentage-point slowdown in annual growth, demography (‘population’) accounts for 1.25 points, while ‘productivity’ accounts for the remaining 0.25 points. Next question: what can we do about it? Well, Mr Costello starts with a simple but important point. When you think about it, you realise that GDP growth isn’t what the materialist game’s about. What matters to our material standard of living is the growth in GDP per person. So, to the extent that slower GDP growth is caused simply by slower population growth, it isn’t a worry. When you strip out pure population growth, you discover that the projected slowdown in the growth of GDP per person is smaller: from 2.25 per cent a year over the past 40 years to 1.5 per cent a year over the coming 40. But, even so, most people—and, certainly, most economists— would prefer to prevent that slowdown in the rate of improvement in our material living standard if they could. So, again, what can we do? Mr Costello makes the point that, despite all the recent talk,

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raising the fertility rate (the average number of children each female is expected to have over her lifetime) wouldn’t help. Designing effective policies to increase fertility is a lot easier said than done. But, even if you could get fertility up in a hurry, it would worsen the growth in GDP per person, not improve it. Why? Because what contributes to GDP per person is the extent to which the working-age population grows faster than the general population (assuming there are jobs for all your extra workers). And a new baby boom would tip the balance the other way. Think of it like this: we’re worried about what all the extra retired people will do to worsen the ratio of dependants to workers. Adding a lot of children would be adding to the dependants. Of course, once the babies were old enough to work, that would be a different matter. So, from a living-standards perspective, higher fertility would make things worse before it made them better (and it could take 30 or 40 years before we made the transition). Increased immigration would help boost GDP per person—provided the emphasis was on bringing in young workers rather than people too young or too old to work. But, really, Mr Costello’s point is that the ‘population’ part of the equation is too hard to influence. Government policy can far more easily influence the two other parts: participation and productivity. You’ve heard the economists’ standard sermon on why and how to improve productivity lots of times before, so it’s the ‘participation’ part that needs emphasising. The more we can do to encourage the baby boomers to keep working and delay their retirement—or the more they choose to do so for their own reasons—the less will be the slowdown in GDP per person. (For every boomer who continues working, there’s a double benefit to the future dependant–worker ratio: one less dependant, one extra worker.) I suspect this is most of what all the fuss about the ageing population amounts to: the community is in the process of convincing itself that early retirement should give way to later retirement.

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chapter 23

GOOD NEWS AND BAD ON UNEMPLOYMENT

For roughly the first 30 years after World War II, the rate of unemployment averaged about 2 per cent. In 1974, however, everything started to go wrong and for most of the following 30 years unemployment seemed to be steadily getting worse. Unemployment is, of course, highly cyclical, rising during recessions and falling during recoveries. During the three recessions of the past 30 years—in 1974/75, 1982/83 and 1990/91—unemployment positively shot up, but then fell back only very slowly in the years of expansion. And, since each post-recession peak was higher than the last (Figure 23.1), it was easy to conclude that, beneath the cycle, there was an inexorable increase in unemployment. So unemployment has been the greatest single problem bedevilling the economy since the end of full employment in 1974. Concerns about that other great problem of the last quarter of the 20th century, inflation, arose mainly because of the contribution it made to the greater social and economic problem of unemployment. It has to be said, however, that just as we were able to return to low inflation during the 1990s, so in the first decade of the 21st century we seem at last to have made significant progress in reducing unemployment. After a record expansion phase of 119

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12 11 10 9 8 7 6 5 4 3 2 1 0 45/46

Average 1977/78 to 2002/03 (7.5%)

Average 1945/46 to 1973/74 (2.0%)

52/53

59/60

66/67

73/74 Year

80/81

87/88

94/95

01/02

Figure 23.1 Australia’s unemployment rate, 1945/46 to 2003/04 Source: Budget paper no. 1, 2004/05

14 years following the recession of the early 1990s, the official unemployment rate got down to around 5 per cent for most of 2005—its lowest rate in almost 30 years. But can we believe the official unemployment rate? Yes and no. Yes in the sense that, contrary to the suspicions of some people, the unemployment rate has not been fiddled with by the federal government. Our unemployment rate is based on a large and careful monthly sample survey of the population conducted by the Australian Bureau of Statistics. The bureau is independent of the elected government and the definitions of employment and unemployment it uses are those recommended by the International Labour Organisation in Geneva. Those definitions have not changed significantly for many years. But, no, we shouldn’t take the official or ‘headline’ rate of unemployment at face value as the most accurate indicator of the extent of the unemployment problem. This is because the official definition

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of unemployment—as specified by international statistical conventions—is too tight, too narrow. As is well known, a person who has worked just one hour in a week is classed as employed, even though that person may merely have picked up an hour or two’s casual work in the course of their search for a full-time job. As well, a person who would like to have a job, but hasn’t been actively seeking one, is classed not as unemployed but as ‘not in the labour force’—that is, they are left out of the figures completely. Economists refer to such people as ‘discouraged jobseekers’. Surveys suggest that more than half of these people are mature-age workers, aged 45 to 64. There is, in other words, much ‘hidden unemployment’. In an article in the March 2005 edition of Economic Papers, Fred Argy calculates a more comprehensive definition of unemployment, which he labels ‘total joblessness’. Mr Argy is a former senior econocrat. He starts with the (roughly) 600 000 people counted as the headline unemployed, then adds a further 600 000 to account for all those people with part-time jobs who’d prefer to be working longer hours—the ‘under-employed’. Then he adds 200 000 to account for those discouraged workers who would work if the right job was available. However, not all of those in part-time jobs are wanting more hours of work—and not all of the discouraged workers would want to work full time. (Remember that many people—including young mothers, full-time students and the semi-retired—are perfectly happy working part time.) So Mr Argy makes a deduction of 500 000 to allow for the lesser hours being sought by some people. This brings him to his estimate of total joblessness of 900 000 people, roughly equivalent to 9 per cent of the labour force. So the ‘true’ rate of unemployment may be nearer 9 per cent than 5 per cent. There are a few things to remember, however. First, these estimates are highly approximate because of the inadequacy of the figures available. Second, don’t take the figure of 9 per cent to mean that, since the official unemployment rate hit a peak of almost 11 per cent in the early 1990s, we’ve made little progress in

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getting it down. You have to compare like with like. So if you take the official unemployment rate of 5 per cent in 2005 and adjust it upwards to take account of hidden unemployment, you have to do the same with the official unemployment rate of 11 per cent in the early 1990s. Were you to do this you’d still find we’d made a lot of progress in reducing unemployment—though perhaps not quite as much as a simple comparison of the official figures might suggest. Finally, Mr Argy’s estimate is reasonably consistent with a roughand-ready rule of thumb that the ‘true’ rate of unemployment is roughly double the official rate. But what are the factors keeping the total rate of joblessness at 9 per cent? Unemployment has a range of causes or potential causes, which line up with the various types of unemployment listed in textbooks. Breaking up the total unemployment rate between these causes or types will always be a pretty arbitrary exercise, but Mr Argy chances his arm. The first type is frictional unemployment. Frictional unemployment is always present because, at any point in time, there will always be a number of people moving between jobs—those who’ve left one job but are yet to find or take up the next. It’s thus inevitable and a perfectly healthy occurrence. Mr Argy puts the rate of frictional unemployment at 2 per cent—which coincides with the definition of full employment used before unemployment moved into its dysfunctional period in 1974. The second type of unemployment is Keynesian unemployment, also known as cyclical unemployment. Keynesian unemployment is that unemployment caused by a deficiency in aggregate demand (‘deficient demand’) relative to the overall productive capacity of the economy. It recognises that the demand for labour is ‘derived’ from demand for the goods and services that workers are employed to produce. With the economy having grown continuously and strongly since the recession of the early 1990s, you wouldn’t expect actual production (reflecting the demand side of the economy) to

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be falling far short of the economy’s potential level of production (determined by the economy’s capacity to supply). That is, you wouldn’t expect the ‘output gap’—the difference between actual and potential production—to be large. Remember that unemployment—correctly measured—represents the economy’s unused supply of labour. Nevertheless, Mr Argy estimates that Keynesian unemployment accounts for about 1 percentage point of the total joblessness rate. The third type of unemployment is voluntary joblessness. This refers to people of working age who are on social security benefits and who have no strong incentive or motivation to actively look for work. Internationally, this issue has attracted much attention from conservative economists in recent decades. They have argued that many people remain unemployed because they can live well on unemployment benefits without the bother of working. In many European countries, the amount of unemployment benefits is a high percentage of the person’s previous wage. In Australia, however, the dole is flat-rate (everyone gets the same weekly amount), means-tested and a quite low percentage of the minimum wage. What’s more, the dole is subject to stringent ‘activity testing’—to continue receiving it, you must be able to demonstrate that you have been approaching potential employers. So it is hard to see that voluntary unemployment could be much of a problem in Australia. Even so, Mr Argy estimates that voluntary unemployment may account for about 1 percentage point of the total joblessness rate. The fourth type is classical unemployment. ‘Classical’ is a reference to the conventional neo-classical model of markets, where demand and supply are brought into balance by changes in price. So classical joblessness occurs when wage levels are too high relative to the ‘market-clearing rate’ (the wage rate which would allow employers to profitably employ all jobless workers, including those with relatively low marginal productivity). According to the theory,

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it is caused by government-created rigidities in wage-setting arrangements (such as a high minimum wage or over-aggressive trade unions) which prevent the jobless from bidding down wages to a level that is profitable for employers. With the general level of wages now growing in line with the growth in the productivity of labour, this cause of unemployment is likely to relate mainly to unskilled workers, whose productivity may be further reduced by poor health or low literacy, and to the lowest minimum wage. Mr Argy says few economists believe there would be no employment gain from an appreciable cut in real wages, especially as, by international standards, Australia’s minimum wage is high relative to average earnings. Even so, there is much disagreement over estimates of the elasticity of wages—that is, over how far real wage rates need to fall to have much effect on employment. Mr Argy concludes that classical unemployment may account for about 1.5 percentage points of the total joblessness rate. The fifth and final type is structural unemployment. This arises where the skill, age, location and other personal characteristics of the jobless are out of kilter with those sought by employers. It reflects a ‘mismatch’ between job vacancies and jobseekers, leading to an oversupply of workers with particular skills and personal characteristics or in particular locations—at the same time as there may be shortages of other kinds of workers. Structural unemployment’s basic cause is the inability of workers to change their skills or where they live in response to changes in employers’ demand for labour (in turn arising from changes in consumer demand and, particularly, changes in the technology used to produce and distribute goods and services). Mr Argy says this is the largest component of joblessness and estimates that it may account for 3.5 percentage points of the total joblessness rate of 9 per cent. Mr Argy reminds us that work is unevenly distributed not only between households, but also between parts of Australia. Jobless rates are appreciably higher and of longer duration in South

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Australia and Tasmania than in other states, higher in regional and rural towns than in capital cities and higher in the outer lowincome suburbs than the inner high-income ones. The duration of officially measured unemployment is a lot longer today that it was in the 1970s—the median duration is now about 19 weeks, compared with ten in the good old days. So while there are fewer jobless people now than there were in the early 1990s, they are staying jobless for longer periods. The people most vulnerable to long-term joblessness or underemployment are the over-50 year olds, sole parents, indigenous Australians, people with disabilities and migrants with poor English, Mr Argy says. The good news on unemployment is that it’s no longer getting steadily worse and, indeed, has improved a lot in recent years. The bad news is that joblessness is much greater than the official unemployment rate suggests and that we’ve got a lot further to go. But even this carries an element of good news. If the true rate of unemployment is much higher than the official rate, this means we need be less concerned that continued growth in the economy will cause us to run out of labour, pushing the actual unemployment rate to the point where shortages of labour cause a surge in wage and price inflation—that is, to a point below the ‘non-accelerating-inflation’ rate of unemployment, or NAIRU.

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chapter 24

HOW WE TAMED INFLATION

The Reserve Bank sees itself as the community’s chief guardian against the evil of inflation—that is, against large and persistent rises in the general level of the prices of goods and services. The Reserve’s vigilance is reflected in its policy target: to hold the inflation rate between 2 and 3 per cent, on average, over the cycle. The Reserve justifies every change in monetary policy (in the level of the official interest rate) by reference to how it’s going in achieving that target. But to anyone under 30, all this worrying about inflation must seem odd. Over the past 15 years, the inflation rate has averaged 2.6 per cent. Really? What is there to get excited about that? Well, nothing. It’s just that it’s almost 15 years since the end of Australia’s part in a global phenomenon that’s come to be known as the Great Inflation—the world’s only lasting episode of inflation in peacetime (no, it’s not a misprint). Our inflation rate hit 17 per cent a year in the mid-1970s and averaged 10 per cent for the decade (Figure 24.1). In the 1980s, at 8 per cent the average wasn’t much better. Prices rising by 8 to 10 per cent a year for the best part of two decades? It wasn’t very pleasant—and it caused a lot of disruption to the economy. 126

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30 25

Per cent

20 15 10 5 0 -5 45

55

65

75

85

95

05

Year

Figure 24.1 The inflation rate—annual percentage change in CPI Source: ABS

High rates of inflation add to business and consumer uncertainty, and tend to discourage investment. They make it harder for people to discern, and react to, changes in relative prices—that is, the price of one good relative to the prices of others—which economists believe is a key element in the efficient functioning of markets. Large rises in the general level of prices make it easier for firms to conceal their mistakes by passing the cost on to their customers. And high rates of inflation make it harder for workers to win real increases in their pay. Our tax system is built on the implicit assumption that there is no inflation. So the presence of inflation causes distortions in the system which, in turn, distort economic behaviour. It encourages firms to borrow rather than use equity capital and encourages

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investment in appreciating assets (such as real estate) rather than depreciating assets (such as plant and equipment). Some people imagine that inflation is a bigger problem for the rich than the poor. But it’s the other way round. There are strategies people can adopt to protect themselves from inflation or even profit from it. But only the rich can afford to pay for advice about those strategies. So now you know why oldies still have a healthy respect for the dragon of inflation, why economists still worry about it, and why central banks still regard keeping inflation moderate as their first responsibility and the key to keeping economies strong and unemployment low. So how did the Great Inflation happen? To understand that, we need to hark back to two terms you rarely hear these days, the two potential causes of inflation: ‘demand-pull’ pressure and ‘cost-push’ pressure. Demand-pull inflation occurs when demand grows more strongly than supply, putting upward pressure on prices. It’s the common cause. By contrast, cost-push inflation comes from the supply (production) side of the economy. It occurs because firms have sufficient pricing power to be able to preserve or increase their profit margins even when demand is weak. And unions have sufficient bargaining power to win big wage rises. Until the 1970s, demand-pull inflation was the only kind of inflation most economists thought about. The Keynesians’ ‘Phillips curve’ told them they faced a simple trade-off between inflation and unemployment. If you wanted low inflation, you had to accept higher unemployment; if you wanted low unemployment, you had to accept higher inflation. By the mid-1970s, however—after the first oil shock of 1973 had contributed to a huge jump in inflation and the economic managers’ fumbled reaction had plunged the world into its deepest recession since the 1930s—the industrial countries found they’d entered the utterly unprecedented nightmare of ‘stagflation’: the

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combination of high inflation with a stagnant economy and high unemployment. What were you meant to do about simultaneous high inflation and high unemployment? Dampen demand to fight inflation or stimulate demand to fight unemployment? And how had such a contradictory situation occurred? It took the economics profession years to reach broad agreement on the answers to those questions. Predictably, they started with macroeconomic demand management. Unemployment might be a greater evil than inflation, but to return to low unemployment, you first had to get inflation under control and keep it there. Real wages, which had exploded under the Whitlam Government, had to be brought back in line with the productivity of labour. Eventually, however, people realised it must be cost-push inflation that caused inflation to stay high while the economy was stagnant. And it was decades of creeping government intervention in the economy that had left us with a cost-push problem. Inadequate competition in markets gave businesses the power to pass any cost increases straight on to their customers and so preserve their profit margins. This made them less resistant to excessive wage demands and so permitted their unions to appropriate to themselves some of the employers’ pricing power. As well, the centralised wage system could grant national wage rises that were too high, and also take a big pay rise in one industry and quickly cause it to ‘flow on’ to workers in all other industries. So how, after the best part of 20 years, did we finally get inflation down to 2 to 3 per cent in the 1990s? The deep recession of the early 1990s helped, but by itself wasn’t enough to produce sustained low inflation. A much more disciplined approach to macro management—particularly the adoption of an inflation target to guide the conduct of monetary policy—and our return to low inflation expectations played a big part.

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But I think the biggest part was played by microeconomic reform—the removal of import protection, the deregulation of many industries, competition policy and the move to enterprise bargaining. By making many industries more intensely competitive, micro reform largely eliminated cost-push inflation pressure and thereby freed us from stagflation.

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chapter 25

WHY WE WORRY LESS ABOUT THE CURRENT ACCOUNT DEFICIT

In 2005 we achieved a dubious distinction: the trade deficit reached a record level, the current account deficit (CAD) reached a record level and foreign debt reached a record level. Peter Costello professed to be unconcerned about this marked deterioration in our external position—but he would say that, wouldn’t he? Well, yes, he would. But let me tell you something: most of the econocrats, academic economists and business economists agree with him. It wasn’t always true but, these days, only some economists think there’s much reason to be concerned about the size of the current account deficit—which is the trade deficit plus our net interest and dividend payments to foreigners—and the resulting foreign debt. Why not? Because so much has changed since the Banana Republic days of the mid-1980s when many economists were worried. There are six reasons they’ve changed their tune. The first is that Australia has run a CAD in all but two of the past 50 years and, indeed, for nine years in every ten since the First Fleet arrived. This is because we’re a young country with great potential for development, but we’re never likely to save enough money to finance all the investment we could be doing. So we’ve always invited foreigners to bring their savings to Australia and 131

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participate in our development. We’ve always been a ‘capitalimporting country’, and this surplus on the capital account of the balance of payments has always allowed us to run a deficit on the current account. No economist believes that if something’s called a ‘deficit’ it’s automatically bad. Most economists believe it’s natural, normal and even desirable for Australia to run a CAD every year. That was an old truth economists had to rediscover. The second reason they’ve calmed down is their belated discovery that the CAD is cyclical. It’s not in the process of going up and up forever. It’s all very well for the Opposition to talk about the CAD reaching a ‘record’ of $X billion in this quarter or that. Since the economy grows a bit bigger every quarter, it’s not hard to discover new ‘record’ levels if you make no allowance for inflation or the economy’s real growth. When you do make such an allowance, however—by expressing dollar amounts as a proportion of GDP—you discover the CAD goes up and down like a yoyo (Figure 25.1). It regularly reaches a cyclical peak of about 6 per cent of GDP, then eventually falls back to a cyclical trough of about 3 per cent (it was 3 per cent in 2001/02). The strongest cyclical influences are the increases and decreases in imports as domestic demand booms then falls back. But other factors contributing to the cycle are drought and its effect on rural exports, and the varying demand for our exports as the world economy goes through its own cycle. So the CAD tends to reach a peak when our economy is growing faster than the world economy—and is thus importing more than it is exporting—often with a local drought thrown in for good measure. The CAD tends to reach a trough when our economy is in recession—and thus taking fewer imports from the rest of the world—although that wasn’t true of the trough in 2001/02. When you think about it you realise that ‘net exports’—the volume of exports minus the volume of imports—tend to act as a

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0 -1 Per cent of GDP

-2 -3 -4 -5 -6 -7 -8 80

82

84

86

88

90

92

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96

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00

02

04

Year

Figure 25.1 Current account balance—spot the cycle Source: ABS

stabiliser for the domestic economy. When domestic demand is strong, much of the excess demand spills over into imports, thus limiting any build up in inflation pressure; when domestic demand is weak, much of the fall-off is in the volume of imports, thus limiting the decline in production and employment. The third reason economists are less concerned about the CAD is the federal budget’s sustained return to balance. A balanced budget means the public sector is saving as much as it invests and so is making no direct contribution to the CAD. In other words, the CAD is now solely the product of the private sector’s decisions about how much to save and how much to invest. The fourth reason is that microeconomic reform has transformed the private sector. Many years of reform—plus the return to low inflation—have greatly reduced the likelihood that private sector decisions about saving and investment are being significantly distorted by government interventions in markets or by the effect of high inflation on the tax system. This could not have been said

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in the mid-1980s, when concern about the CAD and the foreign debt was at its height. The fifth reason for reduced concern is that economic indicators suggest the CAD is sustainable. The standard way of measuring the difficulty we face in servicing our foreign liabilities—that is, in meeting our obligations to make interest and dividend payments to foreigners—is to compare those payments (the ‘net income deficit’) with our export earnings. The net income deficit reached a peak of 26 per cent of export earnings in 1990/91, but has since fallen to 16 per cent. As well, the amount by which the interest rate on Australian ten-year government bonds exceeds the rate on equivalent US government bonds is often taken as an indicator of the ‘risk premium’ foreigners attach to lending to Australia. This differential averaged 3.5 percentage points in the 1980s, but has since fallen to about 1 percentage point. The sixth reason for reduced concern is the change in the economy’s exposure to a sharp fall in the dollar. What’s the worst that could happen as a result of our high CAD and high level of foreign debt? It would be for foreigners to lose confidence in the way our economy was being managed and become reluctant to lend us any further money. Were this to happen, it would bring about a sharp fall in our exchange rate. There was a time when many economists found such a prospect worrying, but several things have become clearer since then. For one thing, a sharp fall in the dollar would not lead to any corresponding increase in the Australian-dollar value of our net foreign liabilities. A surprisingly high proportion of our foreign debt— about 40 per cent—has been borrowed in Australian dollars. (The world’s willingness to lend to us in our own currency is itself a sign of its confidence in the quality of our economic management.) Most of the rest of our foreign debt—the part borrowed mainly in US dollars and euros—has been borrowed by our banks. And the

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‘foreign exchange risk’ associated with this foreign-denominated debt has been ‘hedged’—covered by a sort of insurance. Turning from our debts and other liabilities to foreigners to their liabilities to us—that is, our assets—almost all of these are denominated in foreign currencies. So a fall in our dollar would actually increase the Australian-dollar value of our assets. Thus the potential currency loss that would arise from a sharp fall in our dollar is being borne by foreigners, not Australians. For another thing, we know from experience—ours and other countries’—that even big movements in a country’s exchange rate no longer have much effect on its inflation rate. Presumably, this is because importers have adjusted to life in a world of floating currencies and tend to hold their prices steady for competitive reasons. Finally, we’ve learnt from the experience of the early 2000s that even very large falls in our exchange rate—say, to US50c—don’t cause great disruption to the economy. So, should another such fall occur, the Reserve Bank would be unlikely to react by trying to halt the decline with a sharp rise in interest rates that risked precipitating a recession. In part, the world has changed since the great CAD concern of the 1980s. In part, we’ve changed our world by such things as microeconomic reform and improved macro management. And in part, we’ve just become older and wiser.

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chapter 26

THE DISTRIBUTION OF INCOME

Everyone knows the gap between the rich and poor just keeps getting wider. Pick up the paper and you see another multimillion dollar handout to some big business boss. Trouble is, our casual impressions have run well ahead of the facts. The Bureau of Statistics’ figures for the distribution of income between all Australian households in 2002/03 show only a small worsening in that distribution over the eight years since 1994/95. If you find that hard to believe, you may find it a bit easier when I explain exactly what it is the figures are measuring. When there’s talk of the gap between rich and poor, many people think about what’s happening to the wages and salaries of employees. The wages of workers at the bottom of the heap seem to be growing only modestly, whereas the executives at the top seem to be awarding themselves huge increases in their salary packages. When you think about it more deeply, however, you realise that what’s happening to wages is only part of the story. For a start, not everyone in the land is an employee. And while some employees live by themselves on their own wage, many others share their wage with a family and there are plenty of two-wage families. So it makes more sense to look at the distribution of income between households than between individual employees. 136

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And don’t forget that wages aren’t the only form of income. In fact, only 58 per cent of Australia’s 7.6 million households have wages and salaries as their principal source of income. The main source of income for 27 per cent of households is government pensions or benefits. These would include age pensioners, the unemployed, the disabled and many sole parents. Then there’s 7 per cent of households whose main source of income is their own unincorporated business (note that many small businesspeople count as employees of their own company) and 8 per cent of households whose main income comes from rent, interest, dividends or private pensions. Yet another factor we ought to take account of is income tax. Some people have a big bite taken out of any extra income they earn, whereas others would lose much less. So you see, even if it were true that the gap between the highest and lowest wages was widening, this wouldn’t necessarily mean a widening gap between the richest and poorest households. A host of other factors could be working in the opposite direction. One commonly used measure of income inequality is the ‘Gini coefficient’. If income was equally distributed between households, the coefficient would be zero. If all the income was held by one household, the coefficient would be 1. So the lower it is, the better. The figures show that the distribution of gross income (that is, income from wages and other private sources plus pension and benefit payments from the government) has a Gini of 0.42. But when you take account of income tax (that is, when you move from gross income to disposable income) the Gini falls to 0.37. So, because income tax hits the rich harder than the poor, the distribution of disposable income is less unequal than is the distribution of gross income. Wait, there’s more. So far, we’ve been comparing households without regard to how many people are in them. We’ve been unconsciously assuming that a family of four on $1000 a week is as well off as a single person on $1000 a week. Obviously, the comparison

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would be more meaningful if we took account of differences in the size and composition of families (an extra adult is more expensive than an extra kid). You can do this using something called an ‘equivalence scale’, and if you use the modified OECD scale you find the Gini coefficient falls to 0.31. (The fall tells us that the higher household incomes tend to be shared among more people.) Now, the equivalent Gini in 1994/95 was 0.30. So there’s been an increase over the eight years, but it’s quite small. And it’s the same story if you look at the change in the Ginis for gross income or disposable income. But why, contrary to all our expectations, has the widening in the gap between rich and poor been so small? Unfortunately, the bureau doesn’t say, preferring to leave such interpretation of the data to academics and other private experts. And neither does it break its figures down sufficiently for anyone who hasn’t done their own fullblown analysis to be sure they know what’s gone on. But the figures do show that, since 1994/95, there’s been a decline in households’ dependence on government benefits plus a decline in the proportion of families with no income-earners, and a corresponding increase in the proportion with one income-earner. So it may be that the effect of any continuing widening of the gap between high and low wages has been counteracted by the effect of a fair proportion of the extra jobs created over the eight years (including part-time jobs) going to formerly jobless families. Be that as it may, there are a couple of other points to remember. One is that, even if the change in income inequality over the eight years was small, this doesn’t mean there was little worsening during the previous ten or twenty years. And it’s certainly not saying the gap between rich and poor isn’t wide. It is—among the widest in the developed world. One way of judging the size of that gap is to rank all households from lowest income to highest, divide them into 20 per cent blocks (‘quintiles’), and then see what proportion of the nation’s total

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income each block managed to pull in. Using the figures for disposable income adjusted by the equivalence scale, we see that the bottom 20 per cent of households have only 8 per cent of total income and the next poorest 20 per cent have 13 per cent. The 20 per cent of households in the middle have 17 per cent. That leaves the second richest 20 per cent with 24 per cent and the top 20 per cent with 38 per cent. There’s your gap. The figures also confirm that, on average, city people have higher incomes than country people. Although households outside capital cities make up only 37 per cent of all households, they account for 44 per cent of the poorest fifth of people and only 24 per cent of the richest fifth. Here’s another way to summarise the city–country gap: the median equivalent disposable income of people living in the capital cities was $483 a week per person, whereas the median for people living outside the capitals was only $400 a week. (The overall median was $448 a week.) If those median figures strike you as surprisingly low, it may be because you unconsciously assume that every family’s like yours. You forget all the poor sole-parent families, the unemployed and, in particular, all the couples and singles living in retirement on low incomes. At the risk of a little oversimplification, let’s try this: just who are the poorest 20 per cent of families? Predominantly, they’re the unemployed, age pensioners, the disabled and many sole parents. Who are the next poorest 20 per cent? Age pensioners with a bit of investment income, sole parents with part-time jobs and the working poor. Who’s in the middle? Single-income working families and younger single workers. Who’s in the second-richest 20 per cent? More working families. And who’s in the top 20 per cent? Mostly two-income families, particularly those too young or too old to have dependent kids. Before you take account of family size, the factor that does most to determine where a family lies on the income scale is whether it has two jobs, one or none.

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chapter 27

MANAGEMENT OF THE ENVIRONMENT

Is economics in conflict with the protection of the environment? It doesn’t have to be. Indeed, the insights of economics can be used to make our efforts to protect the environment more effective and less costly. The measures governments take to protect the environment can be divided into three broad categories: regulation, suasion and economic instruments. Regulation—also known as ‘command and control’—is the traditional way to deal with environmental problems. It’s the commonsense approach, which deals with the problem directly. Someone is doing something that’s damaging the environment, so you pass a law prohibiting or limiting that activity. ‘Suasive’ measures involve education and the provision of information and training, as well as forms of ‘moral suasion’ such as social pressure and negotiation. This may sound wimpish but, when you think about it, it’s very important—and it’s being used increasingly. One reason we’ve done so much damage to our environment is that we didn’t understand the consequences of the things we were doing. Farmers, for instance, have unwittingly done great damage to their farms because they didn’t know about the role played by trees, the effects on the water table, the side effects of 140

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fertilisers, and so forth. So providing information and education is important. The aim is to change people’s perceptions and priorities. It should also win more public acceptance of the tougher measures governments take, thus making them more effective. The third category of government measures is ‘economic instruments’. Generally speaking, this is a newer approach, intended to overcome some of the drawbacks of direct regulation. The trouble with regulation is that it’s often expensive and often inflexible: it doesn’t give the people affected by it much room to move. It’s about compulsion, not incentives. The rationale of economic instruments is that they attempt to harness market forces in the service of the environment. They do this by building the costs of the environmental damage borne by the community into the costs faced by the producers and consumers whose activity is doing the damage. Alternatively, they build the benefits of environment-friendly activities into the incomes of the people who undertake those activities. (In the jargon of economists, this process is known as ‘internalising the externalities’.) So, as producers and consumers go about their everyday business of seeking to minimise costs and maximise benefits, their behaviour changes automatically in ways that cause less damage to the environment. Better still, they have an economic incentive to seek technological innovations that reduce the cost of meeting the government’s environmental standards. Thus the community’s environmental objectives are met with less loss of production and consumption. And this should have the additional benefit of reducing resistance to those objectives. For these reasons, governments have been making greater use of economic instruments in recent years. A staff research paper issued in 1997 by the Industry Commission, Role of Economic Instruments in Managing the Environment, outlines the five main classes of economic instruments and the use being made of them.

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The first class is charges and taxes. Charges can be used, for instance, to oblige polluters to pay the cost of the damage they do. Raising the price of polluting activity tends to discourage such activity, while the revenue raised compensates the wider community for the environmental damage this activity has imposed on it. The revenue can be used either to reduce other government taxes or to finance government spending on other measures to improve the environment. Where possible, it’s best if the charge or tax is levied according to the actual amount of pollution emitted. When this isn’t possible, we fall back on taxing the activity that generates the pollution. For instance, it would be better if we could tax the actual amount of exhaust fumes emitted by individual cars. Since this isn’t yet practicable, we fall back on merely taxing the consumption of petrol (though for some years we did tax leaded petrol more heavily than unleaded). Why is it better to tax the emissions rather than the activity? Because it’s the pollution we object to, not the activity. By taxing the emissions, we create a greater incentive for people to invent ways of continuing their activities while generating less pollution in the process. The incentive, of course, is that you’d pay less tax. That’s the funny thing about many environmental taxes: you’ve hit the jackpot when people find (legitimate) ways to avoid paying them. Most state environmental protection agencies have moved to a system of emissions and effluent charges using ‘load-based licensing’. Firms emitting air, water and land pollutants have to be licensed, and the annual fee for the licence is based on the volume and nature of their emissions. Sometimes, government moves to ‘user-pays pricing’ have an environmental aspect. For instance, changing water rates to charges based on recovering the full cost of the water actually used by individual households and firms gives them an economic incentive to use water more sparingly, which

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benefits the environment—particularly if it reduces the need to dam more rivers. The second class of economic instrument is subsidies and tax concessions. Direct subsidy payments by governments and indirect subsidies via tax concessions can be used to encourage activities that reduce or repair damage to the environment. Whereas in the bad old days farmers got tax concessions for clearing their land, these days they get deductions for capital spending on controlling pests and weeds, fencing off degraded areas and planting trees and shrubs. The third class of economic instrument is financial enforcement incentives (such as performance bonds to ensure that mining companies rehabilitate mined areas) and the fourth is deposit refund systems (such as South Australia’s scheme to encourage the recycling of bottles and cans). The fifth class is the most sophisticated instrument, the best economists have been able to come up with: property rights and market creation—better known as ‘tradable permits’. Governments decide the total amount of environmental damage (such as emission or catching of fish) they’re prepared to permit each year, then give or sell to individual firms the right to do their share of the damage. The most efficient firms are permitted to sell some of their rights to the least efficient firms. In this way, governments achieve their environmental standards with the least disruption to economic activity. Firms are given a powerful incentive to find cheaper ways to comply with the standard (and, when this happens, governments can raise the standards they impose). Early examples of the use of tradable permits include the Murray-Darling Basin Commission’s salt credits trading scheme and the Hunter River salinity trading scheme. But, as the authors of the report observe, there’s considerable scope for greater use of economic instruments to protect the environment.

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par t VIII

ECONOMIC POLICIES AND MANAGEMENT

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chapter 28

SHOCKS TO THE ECONOMY

It’s a funny thing. The public debate about the economy often refers to something that doesn’t rate a mention in most courses on economics: ‘economic shocks’. The shocks are what cause all the fun and games in the economy. When the economy’s hit by one, it’s always big news. Macroeconomic management often involves the authorities responding to the effects of shocks to the economy. And as we’ve got further into the pursuit of microeconomic reform, we’ve realised that one of the main objectives—and one of the main benefits of past reforms—is to improve the economy’s ability to cope with shocks. All the talk about making the economy more ‘flexible’ is about increasing its resilience in the face of shocks— which should make the job of the macro managers easier. An economy better able to cope with shocks is one that has greater ‘dynamic efficiency’. So what are economic shocks? And why don’t they rate a mention in economics courses? Well, actually, they do. They just go under another name. Think of the standard, simple diagram of a demand curve intersected by a supply curve. Most of the time they stay where they are and you move along them in search of equilibrium. 147

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PRICE

Supply

Demand 2 Demand 1 QUANTITY

Figure 28.1 Picture of a demand shock

But then things get interesting. Something happens, and one of the curves shifts. The demand curve may shift in to the left, or out to the right (Figure 28.1). Or maybe it’s the supply curve that shifts. Whatever happens, what you’ve had is—you guessed it—an economic shock. Of course, here we’re dealing not with the demand and supply of one particular commodity, but with aggregate demand and supply. (While I’m piling on the jargon, movements along the curves are ‘endogenous’—they’re determined within the model—whereas shifts in the curves are ‘exogenous’— they come from changes that are outside the model.) What all this means is that some shocks affect demand, whereas others affect supply. Whichever side they affect, they can be either favourable (‘positive’) or adverse (‘negative’). Remember the OPEC oil price shocks of the 1970s? That’s why they were called shocks. The main petroleum-exporting countries formed a cartel and jacked up the price of oil which, for oil-importing countries, represented an adverse supply shock. Aggregate supply shifted in to the left because it cost more to produce a given quantity of goods and services. (Note that this describes the position of most developed

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economies. Australia’s position was more complicated because we export oil as well as import it, and we’re a big exporter of a close substitute for oil, coal.) But not all shocks come from abroad. Our home-grown wage explosions of the mid-1970s and early 1980s were also negative supply shocks. They, too, raised the cost of producing a given quantity of goods and services. An example of a positive shock to supply would be some improvement in the functioning of the labour market that lowered the NAIRU—the ‘non-acceleratinginflation’ rate of unemployment. As its name implies, a fall in the NAIRU would mean the economy could produce more goods and services (and, in the process, generate more jobs and reduce unemployment) without this putting upward pressure on wage rates and prices. It’s possible we’re experiencing just such a favourable supply shock now, without being terribly conscious of it. Sometimes, these things can be more apparent in hindsight. But economic shocks can be more mundane than sudden oil price hikes, wage explosions and shifts in the NAIRU. Take, for instance, the business cycle. What is it that causes the economy to move in cycles of boom and bust? Lots of factors contribute, but one of the most important is swings in business and consumer confidence. When the mood of the moment swings from pessimism to optimism—as it did in September 1993 when we learnt we’d been chosen to host the 2000 Olympics, or again in late 1998 when we suddenly realised that the Asian crisis hadn’t laid us low—that’s a positive shock to demand. It means consumers are more willing to open their purses and firms to expand. Conversely, when the mood swings from optimism to pessimism that’s a negative shock to demand. Consumers and businesses are less confident about the future, and scale back spending accordingly. But in a small, open, primary commodity exporting economy like ours, many of the shocks do come from abroad. They take some untangling, however.

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We’re always being hit by terms-of-trade shocks. (Our terms of trade are the prices received for exports relative to the prices paid for imports.) By the standards of most developed economies, our terms of trade are highly volatile. Most of that volatility comes from movements in export prices. A bit more than half our export income still comes from rural and mineral commodities, whose prices are set—in the main—in international auction markets. Now, if we assume our exchange rate is fixed, a deterioration in our terms of trade caused by lower export prices represents an adverse shock to demand. Our economy has suffered a loss of ‘real income’ because a given quantity of exports now buys fewer imports. Conversely, a rise in commodity export prices means a gain in real income and, hence, is a positive demand shock. But, as you well know, our exchange rate isn’t fixed, it’s floating. And it has a tendency to float down when commodity prices fall and up when commodity prices rise. The trick is that a significant movement in our exchange rate is itself an economic shock. Or rather, it’s two opposite shocks. A sharp fall in the dollar increases the demand for our exports and import-competing goods, so it’s a positive demand shock. But it also raises the price of imports, which is a negative supply shock. (Naturally, a rise has the opposite effects.) Economists believe a fall in the dollar has an expansionary effect on economic activity, meaning they believe the positive shock to demand outweighs the negative shock to supply. And what this means is that, when the dollar falls in response to a fall in world commodity prices, it helps to offset the blow to demand caused by the deterioration in our terms of trade. In other words, our floating exchange rate acts as a kind of shock absorber. We’re hit by an adverse terms-of-trade shock, but the dollar’s fall offsets the blow to a greater or lesser extent. As part of this, it shifts some of the pain from our commodity exporters to our importers. The exporters have suffered a fall in the

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foreign currency price they receive for their product, but that foreign currency now buys more Australian dollars than it used to. The bad news for the importers is that the Australian dollar price of the stuff they’re importing is now higher. Has all this theorising any practical application? You bet. It helps explain why the Asian crisis—an economic shock if ever there was one—didn’t hit us as hard as it might have. So, when economists thought about why the crisis had hit us less hard than expected, they gave a lot of credit to our floating exchange rate doing the job it’s supposed to do. But they also gave credit to micro reform more generally. They decided that all the reforms had made our economy more flexible and more resilient to shocks.

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chapter 29

MACRO MANAGEMENT AND THE BUSINESS CYCLE

Economists keep telling us the economy moves in cycles. So if it’s down now, sooner or later it’ll go up. And once it’s been up for a while, it’ll go back down again. If you’ve any reason to doubt this, a look at Figure 29.1 should convince you. Though the economy’s production of goods and services—real GDP—has grown at an average rate of about 3.2 per cent a year over the long term, at the top of the cycle it can grow at a rate of 6 per cent or so, whereas in severe recessions it can go backwards at a rate of 2 or 3 per cent. But though economists keep reminding us about the existence of the ‘business cycle’, as they call it, they rarely bother to explain why the economy moves in this up-and-down fashion. So I thought that, just for once, I would. What are the factors that produce this strange—and hardly desirable—pattern? Borrowing a bit of jargon from the medicos, economists divide the factors into two categories: endogenous and exogenous. Endogenous factors are those that are produced within the system—within our economy—by its own workings. Exogenous factors are those that come from outside the system but have an effect on it. The obvious exogenous factor bearing on our economy is the rest of the world. The cyclical behaviour of the world 152

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10

153

Real GDP

8 6

Per cent

4 2 0 -2 -4 -6 -8 45

55

65

75 Year

85

95

05

Figure 29.1 A photo of the business cycle (percentage % change on the previous year) Source: ABS

economy helps to explain the cyclical behaviour of our own economy. The world’s demand for our exports, for instance, waxes and wanes—as do the prices the world pays for our rural and mineral commodity exports in particular. But there’s a second, less obvious, exogenous factor: the government’s macroeconomic policy changes. When you think about it, these aren’t produced by the economy but are a discretionary response to whatever the economy’s doing. The goal of macroeconomic management is actually to counter the business cycle: to smooth out the ups and downs as much as possible. These days, the main instrument used to ‘stabilise’ the economy—to keep the growth rate steady and inflation and unemployment low—is changes in official interest rates. When macro management is successful, it reduces the ‘amplitude’ of the cycle—the size of the

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swings in either direction. When it’s done badly, however, it can make the swings bigger than they would otherwise have been. That brings us to the endogenous factors: the ones that are all the economy’s own work. Even if our economy was completely cut off from the rest of the world, and even if governments never lifted a finger, national production would still move in cycles. Why? Because there are various bits of the economy that themselves move in a cyclical fashion. Their combined effect causes the economy overall to move up and down. The first bit is private investment. Business investment in plant and equipment tends to grow rapidly when demand is expanding strongly and firms are running out of spare production capacity, but fall in a heap when demand contracts and firms have excess capacity. But an even more volatile component of private investment is construction, whether it’s the building of homes or the construction of factories, shopping centres, offices and mines. The construction sector seems almost always to be either booming or busting. Why? Because of the potent combination of speculation, bandwagon effects and the long lead times involved in building things. There comes a time when people in the construction business see that demand is starting to outstrip supply and property prices and rents are rising. They see an opportunity to profit and they start building. The trouble is that, once a few people start doing it, everyone else joins in. Eventually, supply catches up with demand. But by the time that message gets through, a lot of people will be committed to projects that it’s too late to cancel. The inevitable result is that supply runs well ahead of demand and the boom turns to bust. Once the committed projects are completed, almost nothing further is built until the excess supply is worked off. Then the roller-coaster starts up again. Linked with the boom-and-bust cycle in the construction of new properties is the cycle in the markets for the buying and selling of

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second-hand assets—which includes the sharemarket as well as the commercial and residential property markets. The booms and busts in these ‘asset markets’ can make some speculators richer and some poorer without necessarily having much effect on the ‘real’ economy—the production of goods and services for consumption. Young Warwick Fairfax, for instance, could blow his family fortune in 1990 without any of the Fairfax newspapers losing a day’s production. But, as we discovered in the early 1990s, the efforts of many businesses to cut back the level of their debts by cutting their costs can have a profoundly depressing effect on employment and production. Another aspect of the economy subject to a cycle is the level of inventories held by manufacturers, rural marketing authorities and retailers. When firms realise they’re holding higher levels of stock than they require to meet expected future sales, they cut back their purchases or their production. They don’t increase them again until they fear their stocks are in danger of running too low. There was a time when the ups and downs of the ‘stock cycle’ had marked effects on the rate of growth in GDP. Yet another factor that helps to cause and accentuate the business cycle is ‘animal spirits’: the successive bouts of pessimism and optimism that affect both businesspeople and consumers. There’s a chicken-and-egg question here: does the ebb and flow of ‘confidence’ cause the cycles in investment, asset markets and inventories, or do those cycles cause the ups and downs in confidence? The answer, no doubt, is a bit of both. I guess I’ve said enough by now to help you understand why capitalist economies are permanently afflicted by the curse we know as the business cycle. It should serve as an antidote the next time you’re tempted by the arguments of those misguided souls who, from time to time, proclaim that the business cycle is dead. But I want to add some reasons for believing that the size of the business cycle has gradually diminished over the long term. The first is that the public sector now accounts for a larger share of

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the economy—and government activities are less cyclical than the activities of the private sector. The second reason is linked with the first. The federal budget contains ‘automatic stabilisers’—in particular, the progressive income tax scale and the availability of unemployment benefits— which cause public demand to expand automatically when private demand is weak and contract automatically when private demand is strong. Third, it’s clear that the stock cycle isn’t as destabilising a force as it once was. Why not? Partly because the advent of computerised stock control and management techniques such as Just-in-Time inventory management has given firms tighter control over the level of their stocks as well as causing stock levels to be smaller relative to sales. And also because the services sector’s greater share of the economy means that more of the firms in the economy simply don’t hold stocks. There is some evidence that the amplitude of the business cycle has been smaller in the period since the war than it was in the earlier part of the century. Do you find that hard to credit? If you do, there are two possible explanations. The first is that, even if the size of the swings in GDP is smaller, the size of the swings in unemployment has definitely got bigger over the past 30 years. Why? Because, in company with most developed economies, our labour market has become progressively less able to cope with swings in GDP. Much of what starts out as cyclical unemployment becomes structural—long-lasting—unemployment. But if the size of the swings in GDP hasn’t diminished as much in practice as it should have in theory, the explanation may be that government efforts to smooth the cycle with their macro management have made things worse rather than better.

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chapter 30

THE CHANGED POLICY MIX

In economics, not much is set in stone. Several years into the Howard Government’s term it made a change to what economists call the ‘policy mix’, also more formally known as the ‘assignment of instruments’. The managers of the macro economy have a range of policy objectives and a range of policy ‘instruments’ to achieve those objectives. They have to decide which instrument they’ll use to achieve which objective. Historically, macro managers have had three objectives. The first is ‘internal balance’, which involves trying to stabilise the growth in demand as the economy moves through the business cycle, and thereby achieve low inflation and low unemployment. The second is ‘external balance’ (or external stability), which means trying to achieve an acceptable deficit on the current account of the balance of payments and, hence, a manageable level of foreign debt. The third is a faster rate of economic growth over the medium to longer term, which means a faster rate of improvement in our material standard of living. To meet these three objectives, the economic managers have at their disposal three instruments: monetary policy (the manipulation of interest rates), fiscal policy (the manipulation of government spending 157

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and taxation) and microeconomic policy (the reduction or reform of government intervention in markets, which is intended to heighten competition and thereby increase efficiency and productivity). Now, in the days of the Hawke/Keating Government, the policy mix was to use monetary policy to achieve internal balance, use fiscal policy to achieve external balance and use micro policy to achieve faster growth. How could fiscal policy be used to achieve a smaller current account deficit? Well, the current account deficit (and the equivalent capital account surplus) represents the amount we have to borrow or otherwise acquire from foreigners to cover the gap between the amount the nation saves each year and the amount it invests (in new physical capital). A budget deficit represents the amount by which the government’s spending on capital works exceeds its saving (which, in turn, is the amount by which its revenue exceeds its recurrent spending). In contrast, a budget surplus represents the amount by which the government’s saving exceeds its investment spending. So using fiscal policy to reduce the current account deficit is straightforward. You keep budget deficits as low as possible and budget surpluses as high as possible. The Howard Government reiterated all this in its first Budget after it came to office in 1996. At the same time it introduced its ‘medium-term fiscal strategy’ of balancing the Budget ‘on average over the cycle’. In the budget papers of 2002, however, the Howard Government let it be known that external balance had been abandoned as a policy objective. It did this both by what the budget papers said and what they didn’t say. The papers explain that the government adopted the medium-term framework ‘to ensure that government finances remain sustainable over time . . . Importantly, adherence to the medium-term fiscal strategy is essential if Australia is to meet longer term fiscal challenges such as those outlined in the Intergenerational Report’. A key goal of the strategy is to ‘improve the level of public saving over time. Achieving higher public saving will contribute to other

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important objectives, including maintaining low levels of Commonwealth general government net debt and stabilising the tax burden’. The thing to note about all this is that it’s a motherhood statement. It’s unarguably true, but it’s the sort of sermon you get from an accountant rather than an economist. It’s not saying much more than that, if you let the two sides of the Budget drift too far apart for too long, you get into bother. And what’s significant about it as an explanation of why we need the medium-term strategy and what the strategy’s meant to achieve is what it doesn’t say: nowhere in that budget statement could you find the words ‘current account deficit’ or ‘foreign debt’. So fiscal policy is no longer being used to achieve external balance. And nor is any other instrument. External balance has simply been abandoned as a policy objective. But if fiscal policy is no longer being used to achieve external stability, what is it being used for? According to the 2002 budget papers, it is now being used to supplement monetary policy in the achievement of internal balance. The papers note that the fiscal strategy’s ‘medium-term focus provides scope for fiscal policy to assist with short-term demand management, while providing an anchor to ensure that spending during periods of weaker economic activity is made possible by savings during periods of stronger economic activity’. They go on to say that ‘expansionary fiscal policy settings in 2000–01 and 2001–02 helped Australia maintain solid economic growth relative to other developed countries during a period of weakness in the international economy . . . it is estimated that there was a stimulus of around 1 per cent of GDP in those years’. For 2002–03, however, the papers say that ‘as the international economy returns to more normal long-term growth rates, it is appropriate to remove this stimulus . . . it is estimated that there will be a contraction of around 0.5 per cent of GDP in 2002–03 from fiscal policy’.

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It’s not necessary to accept that last claim (I didn’t) to accept that fiscal policy’s new role was as a backup to monetary policy. But why has external balance been abandoned as a policy objective? The Secretary to the Treasury, Dr Ken Henry, explained it in a speech he gave in November 2001. ‘A large CAD,’ he said, ‘may be evidence of a national saving problem. But, then again, it might not. It may, alternatively, be evidence of a robust, rapidly growing economy, with a plentitude of attractive investment opportunities—more opportunities than should be, on any analysis, financed by domestic residents. ‘Today, the consensus position is that while both national saving and national investment continue to be of policy interest, the size of the gap between them [the CAD] is of essentially residual interest.’ Why? Because micro reform—‘a highly competitive economy with sound regulatory structures . . . and flexible product and labour markets’—has turned a ‘bad’ CAD into a ‘good’ CAD.

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FISCAL POLICY VERSUS MONETARY POLICY

The more you see of budgets under Peter Costello—his latest unsubtle hints about tax cuts next year, for instance—the more you wonder what they’re for. What role are budgets supposed to play in the management of the macro economy? Well, now we know. The official position—the principle of it, if not always the practice— was spelt out by Ken Henry, Secretary to the Treasury, in a speech to the Conference of Economists in 2003. The first point of note is Dr Henry’s willing acknowledgement that the dominant instrument for the management of the economy is no longer the budget (fiscal policy) but the manipulation of the official interest rate (monetary policy). Monetary policy, of course, is run not by the government, but by the Reserve Bank. The Reserve’s conduct of policy is guided by its inflation target: to keep consumer price inflation between 2 and 3 per cent, on average, over the cycle. Dr Henry is quick to add, however, that pursuit of the inflation target also involves ‘taking account of the implications of monetary policy for [economic] activity and, therefore, employment in the short term’. Why is monetary policy now the dominant instrument of macro management? Because, Dr Henry explains, it’s far better suited to 161

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the job. The use of policy instruments to manage demand in the short term—that is, to smooth out the ups and downs of the business cycle—is subject to three different kinds of lags. The first is the recognition lag—the delay before the economic managers recognise the need to bolster or dampen demand. The length of this lag is the same for fiscal policy as for monetary policy. Second is the implementation lag—the delay between the managers realising they need to act and actually being able to act. This is where monetary policy gains its decisive advantage. ‘Whereas a change in the stance of monetary policy can be implemented almost instantly, the implementation of a fiscal response will be delayed by the time it takes to design an effective intervention, the time it takes to secure parliamentary passage and the time it takes to put in place the administrative apparatus required to implement the intervention,’ Dr Henry says. What’s more, a fiscal measure can take so long to get organised that it arrives after the need for it has passed—after the cycle has turned—so that it adds to the amplitude of the cycle rather than dampening it. The fact that changes in the official interest rate can be implemented within hours of a decision being made means there’s less risk associated with using monetary policy. The stance of policy can be adjusted rapidly—even reversed, if necessary—if the managers realise they’ve misread the situation. Third is the transmission lag—the delay between the measure taking effect and it working its way through the economy to cause the desired response from demand. Dr Henry says the transmission lags associated with fiscal policy can be ‘highly uncertain’. But if, by its nature, fiscal policy is unsuited to ‘fine-tuning’ demand and should have a focus that’s more medium term than short term, what is its role? Well, first, note Dr Henry’s insistence that there remains an activist role for it in emergencies. In a recession, you’d expect it still to be used to ‘pump-prime’ (stimulate) demand.

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In normal circumstances, however, fiscal policy’s role is simply to support monetary policy. The operation of the inflation-targeting regime, he says, is greatly assisted by ‘disciplined fiscal policy’. Illdisciplined fiscal policy can set up problems for monetary policy by destabilising the economy, or by creating inflationary pressures that require a response from monetary policy or that damage its credibility by causing people to doubt its inflation target will be achieved. The Howard Government’s medium-term fiscal strategy (Dr Henry calls it a target) is to achieve ‘budget balance, on average, over the course of the economic cycle’. What does this mean in practice—or, more to the point, what does the government say it means? It means maintaining budget surpluses for as long as economic growth prospects remain sound, ensuring no increase in the overall tax burden from 1996/97 levels, and improving the Commonwealth’s net worth (its assets less its liabilities) over the medium to longer term. Dr Henry says such a target ‘helps deliver macroeconomic stability, encourages private investment in a low interest rate environment, entrenches low public debt and ensures that, over time, the current account [on the balance of payments] reflects private saving and investment decisions’. Now it gets controversial. Dr Henry notes that two concepts— ‘crowding out’ and the ‘twin deficits’ proposition—stand out as recurring themes in the debate about fiscal policy over the past three decades. Note that by crowding out he’s referring not so much to ‘financial crowding out’ via higher interest rates as to ‘physical crowding out’—the idea that, as the economy recovers after a recession, government deficit spending has to be wound back to ‘make room’ for private sector spending as the economy’s idle production capacity is used up. In other words, you get to a point where competition for real resources between the public and private sectors adds more to inflation than to aggregate demand.

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The extreme version of the twin deficits proposition takes the truism that the current account deficit (CAD) represents national investment minus national saving and assumes that any change in the public sector budget deficit causes an identical change in the CAD. Dr Henry says the two concepts are logically incompatible and debunks the twin deficits, noting that, empirically, there’s an almost zero correlation between the twins. The government often repeats a line that balancing the budget over the cycle means the CAD reflects only private sector decisions about saving and investment. Dr Henry says this line represents ‘a summary statement of a conclusion that emerged from a debate on the so-called twindeficits proposition’. But if you think that makes him altogether too complacent about the CAD and foreign debt, note the almighty list of qualifications in this statement of his position (his emphasis): ‘If the government is not making a direct call on capital markets, and if monetary policy is credible, and if markets are flexible, open and transparent, and if markets are supported by credible governance frameworks and institutions, and if confidence is based on these factors rather than on the average level of the current account, then policy-makers can be relaxed about the average level of the current account.’ All those qualifications make it clear fiscal policy should remain interested in the current account, particularly its cyclical behaviour which is often useful as an indicator of the business cycle.

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A DIFFERENT PERSPECTIVE ON MONETARY POLICY

If you think the Reserve Bank’s goal is to get interest rates as low as possible and keep ’em there, you’re sadly mistaken. Indeed, the Reserve’s governor, Ian Macfarlane, said in a speech in August 2002 that very low rates are a bad sign, just as much as very high rates are. And if that hasn’t confused you, try this: though the Reserve is often changing the official interest rate, it’s not really on about getting rates to where the public would like them to be. Even so, I can give you this tip. If you want an idea of where interest rates are headed, you could do worse than take 7.5 per cent as your magic number. If the standard variable mortgage rate is below that number, sooner or later it will go back up. But if it’s above that number, sooner or later it will come back down. All this is a roundabout way of making three points. First, interest rates will always be going up and down, and it’s becoming rarer for them to stay where they are, even for as little as a year or so. But, second, there is a ‘normal’ level for interest rates (or, in economists’ jargon, a ‘neutral’ level), which is neither high nor low, but a happy medium. It’s where interest rates will be when everything in the economy is going well—when it’s neither overheating nor cooling rapidly. And from what Mr Macfarlane has said at 165

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various times, you can work out that, as far as home loans are concerned, the rate’s normal level is about 7.5 per cent. The third point is that, whereas many people imagine low interest rates to be an end-objective of economic management, the Reserve sees rates as a means, not an end. (In the jargon, interest rates are an ‘instrument’, not a ‘target’.) What the Reserve does for a living is known as ‘monetary policy’. And Mr Macfarlane’s speech was entitled, ‘What does good monetary policy look like?’ But he began by spelling out what monetary policy aims to do. The short answer is: achieve sustainable economic growth—keep the economy growing for as long as possible, at a rate that’s not too fast and not too slow. The virtue of economic growth is that it creates employment and raises our material standard of living. What’s wrong with growing too fast? It causes the economy to ‘overheat’. And what does that overworked expression mean? It means that if you allow the economy’s total demand to grow faster than total supply, it leads to inflation—which you eventually have to bring back under control by stomping on demand. What’s wrong with growing too slowly? It means aggregate (total) demand isn’t growing fast enough to fully employ aggregate supply—the economy’s capacity to produce goods and services—and that means you get rising unemployment. How do you judge what’s the just-right rate of economic growth? The Reserve does it by aiming to keep the inflation rate within its target range of ‘2 to 3 per cent on average over the business cycle’. But it also tries to estimate the ‘output gap’—the extent to which aggregate demand seems to be falling behind or running ahead of the economy’s potential to supply goods and services. Mr Macfarlane observes that, though you can use monetary policy to stop the economy’s growth falling below its productive potential, there’s no way it can make the economy grow faster than its productive potential (not in anything beyond the short term). If you’re dissatisfied with the performance of the supply side of the

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economy, the solutions lie in microeconomic reform, not monetary policy. Getting back to the point, however, the next question is: just how does this ‘monetary policy’ keep the two horses of aggregate demand and aggregate supply trotting in parallel? By manipulating the rate of interest, of course. The Reserve raises interest rates when it wants to discourage borrowing and spending to slow demand down a bit; it cuts interest rates when it thinks demand needs a bit of hurry-along. So you see how interest rates are an instrument, not a target; a means, not an end in themselves. You see why the Reserve will be changing interest rates frequently and why, even if rates are at a level most people are happy with, the Reserve won’t hesitate to change them if that’s what’s needed to keep the two economic horses jogging at the same speed. You see, too, why Mr Macfarlane made his surprising assertion that very low interest rates are a bad sign. When a central bank has pushed rates to very low levels, it will have done so because demand is running way behind supply, the economy’s in recession and unemployment is high and getting worse. For proof that very low rates are bad news, try Japan. Japan has an official interest rate of zero (and it would be lower if that were possible). But is everyone dancing in the streets and borrowing and spending like there’s no tomorrow? Hardly. They’re all terribly depressed and not spending much at all. That’s why rates have been slashed to zero—to try to cheer them up. It isn’t working because prices are falling (the rate of inflation is negative), which means ‘real’ interest rates are still quite high. But let’s say we’ve got a healthy economy (which we have)— what would good monetary policy look like? Mr Macfarlane says that nominal interest rates would show neither a rising nor a falling long-run trend. They’d fluctuate a lot, but they’d do so around a stable average. The level of this long-run average would be the level

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that was consistent with a low-inflation growth path for the economy. Since it’s a healthy economy we’re talking about, the inflation rate would neither rise nor fall in trend terms. And that means the long-run average real interest rate would also be stable. Of course, the actual real interest rate (and the nominal rate too, for that matter) would rise and fall as the Reserve adjusted it in response to increasing and decreasing inflationary pressures in the economy. If that didn’t happen—if interest rates never changed—we’d end up with either hyperinflation or deflation (falling prices). Now some sums. Mr Macfarlane has said that the normal or neutral real interest rate is 3 to 3.5 per cent. We’ll call it 3.25 per cent. We know that inflation is supposed to (and does) average between 2 and 3 per cent. We’ll call it 2.5 per cent. That gives us a neutral nominal official interest rate of 5.75 per cent. Add the banks’ interest margin of about 1.75 percentage points on standard variable home loans and that gives us our magic number of 7.5 per cent. It’s a handy figure to keep in your mind and use to judge whether interest rates at the present time are higher or lower than normal.

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MICROECONOMIC REFORM AND PRODUCTIVITY IMPROVEMENT

The search for reasons for Australia’s improved economic performance goes on. Is it the IT revolution? Is it the greater education and skills of the workforce? Over the ten years to 2003, the quantity of goods and services produced by the economy expanded at a rate averaging just under 4 per cent a year—a performance not seen since the 1960s and early 1970s. How did we achieve that? How was it possible to produce 4 per cent more than we produced the previous year, then 4 per cent more than that the next year and 4 per cent more again the year after? The obvious explanation is that we must have used more resources each year—more raw materials, workers and machinery and other capital equipment. And it’s true, we did—but only up to a point. If you take the quantity of goods and services we produced and divide it by the total number of hours our workers put in, you find that, on average over the period, the output of goods and services grew 3.2 per cent a year faster than the growth in the input of workers’ hours. So increased work accounts for only about 0.8 percentage points of the 4 per cent annual growth in output. And that means the improved ‘productivity’ of our labour accounts for 3.2 percentage points of the annual growth in output. 169

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But what made it possible for the typical hour of work we did to involve the production of 3.2 per cent more than it did the year before? Well, a big part of the explanation was something called ‘capital deepening’. It means that our workers were given more and better machines to work with. It turns out that the use of more capital equipment accounts for 1.4 percentage points of the 3.2 per cent annual improvement in the productivity of labour. To put it another way, the increased use of labour accounts for 0.8 percentage points of the 4 per cent annual growth in production, and the increased use of capital accounts for a further 1.4 percentage points. But that leaves 1.8 percentage points of the 4 per cent still to be explained. Economists call this ‘multi-factor productivity’ (MFP), and it’s the growth in output that’s not accounted for by growth in inputs of labour and capital. That figure of 1.8 per cent annual improvement in MFP in the second half of the 1990s was 1.1 percentage points better than the annual MFP improvement we’d managed in the previous 15 years or so. So this is the very essence of our improved economic performance. It pretty much adds straight on to our material standard of living. It’s the bit that represents the magic of the capitalist system—the magic that the socialist economies were unable to match (and which eventually led to their collapse). The planned economies of the Soviet Union and Eastern Europe could increase their production of goods and services by employing more workers and more machines. But they couldn’t achieve any pure productivity improvement on top of that. An economy’s annual rate of improvement in MFP is often thought of as an approximate measure of its rate of technological advance, but actually it’s a ragbag of all kinds of things. It represents the effect of increases in all kinds of efficiency. If the economy is making gains from economies of scale or scope, they’ll show up in MFP. If the structure of an economy’s industry changes—and thus

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the composition of its total production—that will have an effect on MFP, whether favourable or unfavourable. MFP will reflect all those advances in technology that aren’t ‘embodied’ in better machines (and so already counted as part of capital deepening). Remember that, as the Macquarie Dictionary of Economics explains, technology refers to ‘the state of knowledge of the means and methods of production’. It relates to ‘both the process of combining inputs and the methods by which production is organised’. So technology is more than just whiz-bang machines. It includes the know-how in people’s heads about how to organise a factory, an office or any other business. When a boss finds a way to organise her business more efficiently, that adds to MFP. We’ve seen that at the heart of Australia’s faster rate of economic growth is a 1.1 percentage point acceleration in our average annual rate of improvement in MFP. How is that acceleration explained? This is just what Dean Parham, the Productivity Commission’s productivity tsar, sought to ascertain in a paper in 2003. A large part of the US economy’s (smaller) productivity surge in the second half of the 1990s is explained by its increased production of, and use of, information and communications technology (ICT). It is well established that the part of US manufacturing that makes ICT equipment has achieved huge improvements in productivity. When, for instance, a silicon chip factory switches to producing the next generation chip, its inputs hardly change, but the capability of its output may double. But what about the user industries that invest heavily in ICT equipment and know-how— does this raise their productivity? US research confirms that it does. Australia is a negligible maker of ICT equipment, but our industries have invested hugely in ICT hardware, software and know-how. How much of our productivity surge does this explain? Some, but not a lot. According to Dr Parham’s estimates, no more than one- or two-tenths of a percentage point of the 1.1 percentage points acceleration.

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Well, what about the increased education and skills of the workforce? Believe it or not, other researchers have found that, though education and skills made a significant contribution to MFP improvement in the 1980s, it doesn’t seem to have done the same in the 1990s. So, guess what that leaves as the major explanation for the acceleration in productivity improvement and economic growth generally in the 1990s? Got it in one: the effects of microeconomic reform. According to Dr Parham, these policy reforms improved productivity in three ways. First, by sharpening incentives to be more productive, chiefly by strengthening competition from domestic and overseas sources. Second, by opening the economy to trade, investment, technologies and know-how developed overseas. And third, by providing greater flexibility (for example, less regulatory restriction and a more flexible labour market) to adjust production processes and firm organisation to improve productivity. So, the more they study the figures, the more economists satisfy themselves that their prescription of micro reform has worked.

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INDEX

Accord 25–6 ageing of the population 31–4, 115–18 aggregate demand, see gross domestic product agriculture economic shocks to 150 exports from Australia 94 exports from China 87 state support for 80 tax concessions for 103 Allen, Paul 82 animal spirits, see confidence of consumers and businesses Argy, Fred 121–5 Asia Australian exports to 95 financial crisis of 1997-8 109 rising living standards 70 Asian Development Outlook 59–60 asset markets, cyclical 155 asymmetric information, distorts markets 62 Australia Cairns Group founded by 80

‘commodity currency’ 107 comparative advantage of 68 controlling inflation 126–30 current account deficits 131–2 economic growth 159 effects of globalisation 105–11 exports from 9, 88–9, 93–6 foreign investment by 97–100 foreign investment in 99 gross national product 9 imports to 9 income distribution 136–9 information technology in 171–2 price rises in v. US 53 regional variations 124–5, 139 unemployment rates 119–20 Australian Bureau of Statistics 120, 136 Australian Fair Pay and Conditions Standard 29–30 Australian Fair Pay Commission 28 Australian Workplace Agreements (AWA) 26 173

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automatic stabilisers 156 award restructuring 25–7 balance of payments, see current account deficits balanced budgets 133, 157–8, 161–4 banks, interest rate changes 41–5 Battellino, Ric 97–8 birth rate fall 33, 116, see also demographic issues British Petroleum 84 budget constraint 14 budgets, Federal 133, 157–8, 161–4 Buffett, Warren 82 business cycle 149, 152–6, 162 CADs, see current account deficits Cairns Group 80 Camerman, Filip 83 capital, see physical capital cash flow effect of interest rates 38 cash rate 41–3, 46 Castles, Ian 84 certificates of deposit 43 CGS 42, 48, 134 charges, environmental management via 142 chartism 52 child labour 70

China admitted to WTO 79 Australian trade with 94, 105–6 growth of 86–9 China Embraces the World Economy 86 classical unemployment 123–4 clothing industry 80–81, 102 command and control environmental management 140 commercial cash market 42 commodity exports 54, 105–6 commonwealth government securities 42, 48, 134 communications technology 171 comparative advantage 68 competitiveness and exchange rates 51 concentration index 85 conditions of employment 29 confidence of consumers and businesses cyclical tendencies 155 effect of interest rates on 39–40 surveys of, and expected inflation 48–9 swings in 149 Consensus Economics 48 construction, cyclical nature of 154

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consumption and production 8 corporations government support for 101–4 transnational 82–5 cost of funds 43 cost-push pressure on prices 128–9 Costello, Peter budgets under 161 on current account deficit 131 on demographic changes 115, 117–18 credit cards, interest rates on 44 crony capitalism 74 crowding-out 110–11, 163 current account deficits decreasing emphasis on 131–5 effect of globalisation on 108–9 policy mix affects 158 twin deficits proposition 164 cyclical current account deficits 132 cyclical unemployment 122–3 DaimlerChrysler 82 De Grauwe, Paul 83 deficient demand, causes unemployment 122–3 deficit budgets, see fiscal policy demand effect of interest rates 37–40

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equilibrium with supply 15–18 price elasticity of 17 shocks to 147–9 demand-pull pressure on prices 128–9 demarcations, reduced 25 demographic issues 31–4, 115–18 deposit refund systems 143 developing countries 67–71, 80–1 direct investment, see foreign investment discouraged jobseekers 121 diversification, overseas 98 Doha talks 77–81 dole, see welfare payments drug treatments, access to 81 duration of unemployment 125 Dutch disease 108 duty, see tariffs dynamic efficiency 147 economic environmental management 141–3 economic growth 115–18, 166 economic problem, the 13 economic rationalism 59 economics, reasons for studying 3 economies of scale, distort markets 61

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economy how it works 7–11 inflation forecasts 48 role of money in 3–6 shocks to 147–51 effective rate of assistance 102 elasticity 17 elective surgery waiting lists 12–14 emissions taxes 142 employment conditions 29 endogenous factors 152–3 enterprise wage bargaining 26–7 environmental issues approaches to 140–3 effect of industrialisation 70–1 environmental assets 4 equities, foreign, investment in 98 equivalence scale 138 ERA 102 European Union 80, 95 exchange rates as stabilising factor 111, 134, 150–1 economic shocks to 150–1 effect of interest rates on 39 floating, effect of 50–5 speculation in 74 terms of trade and 106–8 exchange settlement funds 41 exogenous factors 152–3 expectations effect 39

expected inflation 46–9, see also inflation exports current account deficits and 132–3 effect of exchange rates on 51 from Australia 88–9, 93–6, 99 from China 87–8 role in economy 7–11 terms of trade and 106 external balance goal 157, 159 external constraint 108–9 externalities 61, 141 Exxon 84 Fairfax, Warwick 155 Federal budget 133, 157–8, 161–4 financial enforcement of environmental principles 143 financial markets globalisation of 110–11 in developing countries 69, 72–6 interest rates and 41–5 overseas, Australian investment in 98 fiscal policy 133, 157–8, 161–4 floating exchange rates 50–5, see also exchange rates Ford Motor Co. 83 foreign exchange 10, 52, see also exchange rates

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foreign investment by Australia 97–100 direct, benefits of 69–70, 73–4 globalisation reduces risk of 109–10 hedging factors 134–5 in Australia 99 in China 88 interest rate differentials attract 55 risk premium on 134 frictional unemployment 122 fuel exports 94, 150 full employment, see unemployment fundamentals 52 Gates, Bill 82, 85 GDP, see gross domestic product General Motors 82–4 Gini coefficient 137–8 globalisation benefits developing countries 67–71 effect on Australian economy 105–11 effect on exports 93–6 foreign investment from Australia 97 of financial markets 72–6 protestors against 77 transnational corporations 85

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Globalisation: Keeping the Gains 67–8 goals of market intervention 62–3 government, see also fiscal policy; Treasury policy; welfare payments dampens business cycle 155–6 environmental management 140–3 financial institutions supported by 74 intervention in markets 59–63, 101–4, 129 macroeconomic policy changes 153–4 Great Inflation 126 gross domestic income, growth in 106–7 gross domestic product 4 as wealth measure 8 cyclic fluctuations in growth 152–6 effect of interest rates on 39 per person 117 v. company turnover 83 gross national expenditure 9 growth, see economic growth Hawke Labor government 25–6, 158 hedging of foreign investments 98–9, 110, 134–5

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Henry, Ken 32–4, 160–4 hidden unemployment 121–5 hospital waiting lists 12–14 ‘hot money’ in developing countries 69, 72–6 household income 136–8 How Big are the Big Multinational Companies? 83 Howard Coalition government 27–9, 157–60 Hunter River salinity trading scheme 143 IBM 82 immigration, economic effects 118 implementation lag 162 imports 9–10 and current account deficits 132 effect of exchange rates on 51 terms of trade and 107–8 income, see also wealth distribution of 136–9 national, sources of 7–8 India, Australian exports to 96 individuals, wealth of 84–5 industrial relations 25–30 Industrial Relations Commission, role of reduced 26–9 industrialisation, effect on environment 70–1 industry assistance 101–4

Industry Commission 141 inflation controlling 126–30, 166 effect of interest rates 37–40 forecasts for 46–9 v. unemployment 119, 128–9 information issues 62–3 information technology 171 institutions, financial, role of 74 intellectual property 80–1 inter-temporal substitution effect 37–8 interest rates differential, and foreign investment 54–5 effect on demand 37–40 on credit cards 44 real, and inflation 46–9 Reserve Bank control of 41–5, 153–4, 165–8 Intergenerational Report 32–4 internal balance goal 157, 159 internalising the externalities 141 International Monetary Fund 72–6 international trade, see trade inventory levels, cyclical 155–6 investment, in business cycle 154 Japan 94, 166 Keating Labor government 25–6, 158

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Keynesian economics on inflation 128 on unemployment 122–3 v. neoclassical 17–18 Labor governments 25–6, 158 labour, see also unemployment deficient demand for 122–3 demographic changes in 31–4 in developing countries 68, 70 market for 21–30 role in economy 4 lags in policy implementation 162 Liberal/National Party governments 27–9, 157–60 load-based licensing 142 Macfarlane, Ian 165–8 macroeconomics business cycle and 152–6 economic shocks and 147 elasticity of prices and 17–18 inflation control by 129 policy mix 157–60 manufacturing industry exports from Australia 93–4 exports from China 87–8 government assistance to 103 terms of trade and 108 market-clearing rate 123

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markets 12–20 concentration index 85 cyclical tendency in 154–5 environmental management via 141 failure of 59–63 financial, and interest rates 41–5 for foreign exchange 52 for labour 21–30 inadequate competition in 129 price regulates equilibrium 15–18 Medicare 12–14 medium of exchange, money as 4 MFP 117, 170–1 microeconomics assumes perfect competition 60 government policy 158 in China 79 inflation control by 130 labour market reforms 23 obsession with prices 15–18 productivity and 169–72 reforms in 160 removal of government intervention 133–4 smooths out economic shocks 151 mineral and fuel exports 94, 150 minimum wages 28–9

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mining, tax concessions for 103 momentum trading 52, 74 monetary policy 157–8 aims of 165–8 effect on inflation 37–40 stance on 46 v. fiscal policy 161–4 money 3–6, see also income; wealth monopolies, distort markets 61 multi-factor productivity 117, 170–1 multiskilling 26 Murray-Darling Basin salt credits trading 143 NAIRU 125, 149 National Australia Bank quarterly business survey 48–9 national industrial relations system 28 neoclassical economics 15–18 net exports 132–3 net income deficit 134 neutral level of interest rates 165, 168 New Zealand, exports to 95 no-disadvantage test 29 non-accelerating inflation rate of unemployment 125, 149 non-globalisers, economic problems 67–8

Office of the Employment Advocate 28 official interest rates 41 oligopolies, distort markets 61 OPEC oil price shocks 148 open market operations 42 opportunity cost determines profit 16 effect of interest rates on 38 of resources 13 optimism, see confidence of consumers and businesses output gap 123, 166 over-full employment 31 Parham, Dean 171 participation in labour force changes over time 33–4 demographic issues 115 need to increase 118 pattern bargaining 30 pensions, see welfare payments performance bonds 143 pessimism, see confidence of consumers and businesses physical capital 4 deepening 117, 170 physical crowding out 163 policy mix 157–60 political power of corporations 85 poor countries 67–71, 80–1

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population changes 31–4, 115–18 portfolio investment overseas 99 poverty, see developing countries; income; wealth price elasticity of demand 17 prices, see also inflation effect on exchange rates 53 obsession with 15–18 of manufactured goods 88–9 of resources 13 price mechanism 16 Prices and Incomes Accord 25–6 production and consumption 8 productivity increases in 22–3 microeconomic reform and 169–2 projected changes in 117 wealth and 6 profit, setting level of 16 property rights, environmental 143 protests against globalisation 77 public saving levels 158–9 public sector 61, 63, see also government purchasing power parity 53 ‘race to the bottom’ myth 69 rationing of resources 14 real exchange rates, see exchange rates

181

real interest rates, see interest rates recognition lag 162 regulation, see government; Reserve Bank rent-seeking behaviour 63 Reserve Bank 37–40, see also interest rates; monetary policy aims of 165–8 inflation regulated by 126 interest rate control 41–6 resources 4, 13, 16 retail cash market 43 retirement, early v. later 118 risk premium on investment in Australia 134 Robinson, Joan 3 Rogoff, Kenneth 72–6 Role of Economic Instruments in Managing the Environment 141 Royal Dutch/Shell 82 rural exports, see agriculture; mineral and fuel exports salinity control schemes 143 saving levels, need to increase 158–9 scarcity of resources 12–14 secret ballots for unions 30 services export from Australia 94 tax concessions for 103 WTO coverage of 80–1

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specialisation 11, 68 speculation in foreign exchange 74 stagflation 128–9 sticky prices 17 stock cycle 155–6 structural unemployment 124 suasive environmental management 140–1 subsidies for environmental management 143 superannuation funds, overseas investment by 97–8 supply equilibrium with demand 15–18 of labour 32–3 shocks to 147–9 surplus budgets, see fiscal policy tariffs benefits of reducing 103–4 China reduces 87 industry protection via 101–2, 104 long-term reductions 68, 78–81 taxation breaks for industry assistance 103 economic management via 142–3

effect on income distribution 137 inflation effects on 127–8 TCF sector 80–1, 102 technology effect on labour market 23 effect on productivity 171 trade promotes spread of 68 terms of trade changes over time 105–8 economic shocks to 150 exchange rate and 53–4 textiles and clothing 80–1, 102 total joblessness 121–5 tradable permits 143 trade 79–81, see also current account deficits; tariffs; terms of trade barriers to 101–2 faster growth through 68 intensity of 105 value to economy 11 trade-weighted index of currency value 55 transactions accounts 43–4 transmission lag 162 transnational corporations, size of 82–5 Treasury policy, on demographic changes 32–4 TRIPS 90–1 TWI 55 twin deficits proposition 164

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unemployment, see also labour actual rates of 119–25 future levels 34 historically low levels 31 increasingly cyclical 156 neoclassical v. Keynesian views 19 v. inflation 128–9 unfair dismissal 28 unions 26, 30–1, 128 United States Australian exports to 95 information technology in 171 price rises in 53 Uruguay talks 78, 80–1 user-pays pricing 142–3 value added, in calculating wealth 83 voluntary joblessness 123 wage setting systems 26–30 effect of economic shocks 149 role in inflation 129

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unemployment caused by 123–4 Wal-Mart 84 water rates, user-pays pricing 142–3 wealth 3–5, 82–4, see also income welfare payments choice to live on 123 to businesses 101–4 to low-income households 137–8 Westpac–Melbourne Institute survey of consumer sentiment 49 wholesale cash market 42 women entering labour force 22, 116 work, total amount of rising 22–3, 169 Workplace Relations Act 26 World Bank, on globalisation 67–8 World Trade Organisation (WTO) 77–81, 87