Mixed progress on reform of power prices

Do you think you're paying too much for electricity? Would you like to see an end to hefty annual price rises, maybe even a fall in prices that goes beyond the abolition of the carbon tax? Well, be patient. The econocrats are working on it.

It may surprise you that they've been in the process of reforming electricity prices for the best part of 20 years, and they're far from finished. They got part of the power system working well, had a bad slip with another bit, and the jury's still out on a third. But they're working away and are confident of success - eventually.

The national electricity market - covering all of Australia bar Western Australia and the Northern Territory - is actually a creation of our econocrats, their grand experiment in market competition.

Before this, we had separate, state-owned monopolies that charged us pretty much what they wanted to charge, particularly because our demand for power kept growing every year. The reformers' bright idea was to link up all the eastern and southern states and turn them into a market by making all the individual power stations compete to feed electricity into the national grid at the lowest prices possible.

Buying the power at the other end of the grid would be various electricity retailers, which would deal directly with households and business users. These, too, would be required to compete with each other to win our business, since we'd be free to buy our power from whichever retailer we chose.

Linking the power stations in the wholesale market with the retailers supplying power to you and me would be the high-voltage transmission and lower-voltage distribution network (the "poles and wires", as pollies keep calling it).

Since it would never be economic to build rival networks, this would have to stay as a monopoly. And being a monopoly, whether it was sold off or remained government-owned, the prices it charged the retailers - and they passed on to us - would need to be closely regulated to prevent rip-offs.

The reform of the first part of the system has worked really well. Competition between the electricity generators has been cut-throat, prices haven't changed much over the years and no power stations are making excessive profits.

But the cost of generating the electricity makes up only about 30 per cent of the retail prices we pay. The big problem has been that faulty rules have prompted the regulators of the network operators' charges to grant them excessive increases, to the point where "network charges" now explain about half of retail power prices.

It's five years of these big increases, much more than the carbon tax or the renewable energy target, that have caused retail prices to grow so fast. A big part of the problem is that, about four years ago, the demand for electricity, which had been growing every year for a century, stopped growing and started falling.
It fell mainly because of new laws requiring appliances to be more efficient in their use of power and because all the fuss Tony Abbott was making about the price of electricity prompted us to be more price-conscious and look for ways to reduce our usage.

The network operators began investing heavily to improve the capacity of the network to meet the ever-higher peak demand for power on hot summer afternoons when a growing number of us had airconditioners going full blast.

One small problem: the fall in annual demand for electricity meant the brief seasonal peak had stopped rising. For several years the industry refused to believe the downturn in demand from the network was more than a blip.

So we've expanded the capacity of the network beyond what we're likely to need for some time. But you and I are paying extra for this expansion and will continue paying until it's paid off.

The good news is the econocrats have finally woken up to the problem. Actually, they were woken up in 2012 by the fuss Julia Gillard made when she realised Abbott was framing her for price rises she didn't cause.

In 2012 the rules were changed to give the regulators greater power to limit increases in the network charges passed on to retailers. Such changes take far longer than you'd imagine to flow through, but from now on it seems likely the network component of retail electricity bills will stay fairly steady in dollar terms.

The econocrats have proposed a further reform which, when it takes effect, will require the networks to bill retailers according to the time of day and time of year when you and I use electricity. With the spread of "smart meters" - which show the precise times when each household uses its electricity - we'll be charged according to our time of use, with those of us who show restraint during peak periods paying less, and those who don't paying more. This should produce a lasting solution to the (expensive) problem of ever-rising peak demand on hot afternoons.

That leaves the question of the effectiveness of competition between the growing number of electricity retailers, big and small. Here the jury is still out. Much depends on how smart we are in finding the retailer offering the best deal - on which quest I offer some tips in my little online video spiel.

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How the econocrats can lift their game

When we judge the performance of chief executives, most of us know the boss who's good at cutting costs isn't worth as much as the boss who's also able to improve the outfit's products and processes. Well, the same goes for treasurers and finance ministers - and their econocrats.

It seems the fiscal managers are running low on good ideas. But not to worry - the former Treasury and prime ministerial adviser Dr Ric Simes, now of Deloitte Access Economics, had some useful advice to offer in a speech to the Australian Business Economists last week.

Simes argues governments themselves have an important role to play in achieving the improved productivity performance the econocrats keep saying we need. Especially when "productivity" is better thought of as "technological progress" and the figures for measured productivity aren't as important as actual improvements in welfare.

"For those parts of the economy where market forces are paramount, government's main role is to make sure that regulation or its own actions allow competition to unfold without unwarranted intervention," Simes says.

To me, this means econocrats should urge their masters to tread carefully when powerful business interests, fighting to shore up a technologically superseded business model, demand that governments make breaches of government-granted copyright a hanging offence.

As Simes says, digital technologies have lower entry barriers and are forcing businesses to be both more productive and more responsive to consumers. So don't help incumbents resist change.

But, he says, the potential for technology to make some of the largest improvements in Australian lives lies in government-heavy sectors including health, education and transport. In these areas, progress has been too gradual.

"The exemplar is probably electronic health records, which have been the focus of considerable effort for perhaps 15 years now, but where we still seem to be a long way off the goal of having them routinely used throughout the health system.

"Or, take even an example where we have done well, the SCATS - Sydney Co-ordinated Adaptive Traffic System - for control of traffic lights. SCATS was originally developed 40 years ago, it has been constantly refined since then and is now in use in 27 countries.

"So, a success story - yet, as a Sydney driver, I know my welfare would be improved with a more refined SCATS system. It's coming - NICTA [the National Information Communications Technology Research Centre of Excellence] and others are working on optical-based monitoring and improved optimisation algorithms - but more support for both the research and especially its deployment would lift my welfare!"

Simes notes that in both cases, electronic health records and SCATS, the strict efficiency improvements from the technology - the bit that would help government budgets - represent a relatively small part of the overall benefits to the community.

"Especially in health and education, many of the benefits will involve improvements in the quality and range of services rather than efficiency gains," he says.

"Making the most effective use of digital technologies in health and education - as well as other areas where government has a direct role, such as smart technologies in transport and utilities - will deliver much larger economic and social benefits than where we seem to like to focus much of our policy attention, such as whether we should get the budget back into balance by 2017 or 2019."

Another potentially major area of micro-economic reform, Simes says, is how we organise our cities. Up to 80 per cent of Australia's output and employment occurs within its major cities. This has happened in the pursuit of economies of agglomeration.

"Yet we know that the problems are mounting. Congestion, compromised open spaces, the loss of amenity all risk detracting more and more from those benefits."

As with digital, many of the benefits from fixing these problems would not show up in our standard measures of welfare derived from the national accounts.

"Ten minutes less travelling time to work, or to school, doesn't have direct effects on gross domestic product. A more vibrant space around the harbour, or convenient shopping centre in the 'burbs, doesn't get picked up. But social welfare is clearly affected," he says.

Taking Sydney as an example, if commuter travel times on its roads were reduced by five minutes per trip, the benefits would amount to $3.6 billion a year, if an individual's time is valued at average weekly earnings.

To this you could add savings for freight or commercial vehicles. And savings for going to the shops, or school, or to the beach.

Echoing the patron saint of treasurers, Simes wants to lift our gaze to "the big picture".

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Digital revolution transforms productivity debate

A second former econocrat has joined former secretary of the Prime Minister's department Dr Mike Keating in seeking to lift the tone of the economic debate.

"We are spending too much effort debating how and how quickly we should bring the Commonwealth budget back into balance," Dr Ric Simes said in a speech to the Australian Business Economists this week.

"We need to elevate the economic debate from the level of catchcries about debt and deficits, or about productivity or even about the use of cost-benefit analyses. We need some deeper analyses being brought to the surface."

Simes, now a director of Deloitte Access Economics, formerly of Treasury and economic adviser to Paul Keating as prime minister, wants to see a more sensible discussion about productivity.
Productivity is obviously important and policy should indeed be focused on lifting it.

"But we do need to be careful about what this may mean in a particular circumstance," he said. One problem is that productivity is being used as a catchcry for myriad causes, often unjustifiably.

Simes agreed with Mike Keating's trenchant observation that "business associations, some leading employers and their camp followers in the media are insisting that future reforms must focus on alleged labour market rigidities and reductions in taxation, as if these were the most important influences on productivity".

And while "there is scope for improved labour relations to make a modest contribution to improved productivity ... the main responsibility for improvements in that regard lie with employers themselves," Keating has written.

"The best thing that employers and their trade associations could do is to stop passing the buck to everyone else for their own failings, and get on with making their workplaces more productive using the existing freedoms that they undoubtedly have," Keating concludes.

Simes adds that this is exactly what most businesses try to do. For his evidence, keep reading.

Simes' second problem with how "productivity" is being used in the debate concerns its measurement. "Productivity is simply a less than perfect measure of economic wellbeing, and having the public debate focus so much on what the Bureau of Statistics reports as productivity can be unhelpful."

Indeed, Professor John Quiggin, of the University of Queensland, had called productivity an "unhelpful concept", mainly because of problems with the way the contributions of labour and capital were measured in its calculation.

Simes agreed with Quiggin that we'd be better off using a term that was closely related to productivity, "technological progress" - that is, the introduction of technological innovations such as new products and improved production technologies.

Rhetoric - the choice of terms - did matter, Simes said, and had we been using the term technological progress instead of productivity, the debate wouldn't have been so open to distortion by vested interests.

"Tax, or industrial relations, or fiscal policy, can and should be refined, but they are not at the heart of why measured productivity weakened after 2000," he said.

But the measurement problem went further. "I think we have a fundamental problem in that our measures of gross domestic product or productivity are becoming less reliable proxies for economic welfare."

If instead of looking at productivity statistics we stand back and look at the way societies and businesses are changing, we find some profound changes under way, particularly the digital revolution.

We see consumers forcing retailers and media companies to transform. His own research had found that, without telework, only 14 per cent of new mums said they would return to work with their old employer, but 61 per cent said they would if telework was available.

His research had found how companies' information technology policies on staff use of social media at work and BYOD - bring your own device - were of growing importance in attracting young and talented employees.

He'd found that businesses able to create a "collaborative" working culture - including through use of digital technologies - succeeded in growing faster than otherwise.

What has this to do with productivity? First, most of the change we were seeing was being driven by individuals, whether they be consumers, workers, students or patients. To a trained economist, this should suggest that economic welfare had probably risen - and risen a lot.

It was hard not to conclude that individuals making deliberate decisions to do something new were adding to their own welfare, and to society's.

But, second, if this isn't showing up in our measures of welfare - such as GDP or productivity - then maybe there was something wrong with those measures. It seemed to Simes that "productivity, as measured, misses many, if not most, of the gains to consumer and social welfare that digital technology is delivering".

It didn't capture the benefits from improved convenience when we no longer had to queue for ages to renew a licence or at our bank branch. Nor the convenience of being able to search for a needed service in a fraction of the time it took before the internet.

It didn't capture the benefits of much greater choice. The Amazon books site, for instance, took costs out of the supply chain (thus reducing prices to consumers) but also provided much greater choice of books in a convenient manner.

Studies by Erik Brynjolfsson and others at the Massachusetts Institute of Technology had estimated that the easy access to a greater choice of books generated seven to 10 times the consumer welfare that the more efficient supply chain generated (the only bit that would make it into measured productivity).

He wasn't saying we should include the benefits of convenience and choice in our measurement of GDP - that wouldn't work.

No. "What I am arguing is that we need to be careful to base policy decisions on a deeper understanding of our objectives and not be driven by simplistic rhetoric," he said.

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Why almost all of us are 'out of touch'

When politicians say things such as that the poor don't buy petrol, it's easy to accuse them of being "out of touch". Actually, all politicians face that accusation before they're through. It's one of our favourite things to say about pollies we disapprove of.

But let's turn it around: exactly how in touch are you and I? Much less than we imagine.

We know a lot about our own circumstances and those of our friends and neighbours, but are surprisingly deficient in our understanding of people outside our circle.

And one of our greatest deficiencies is our inability to see ourselves as others see us, to place ourselves on the spectrum. Take the question of income.

In 1999, researchers at the University of NSW conducted a survey asking people to nominate their family's gross income and then to say where they believed that income placed them in the distribution of all families' income.

The results showed that more than 93 per cent of respondents believed their income to be in the middle 60 per cent of the distribution.

Most of us like to imagine we're middle-income earners. Ask us where we fit and almost no one admits to being either rich or poor (unless they're accused of not using much petrol).

A survey conducted this year for the Australia Institute, found a similar result but put it a different way: nearly all Australians think the average income is the same as their own income.

Of those respondents reporting their own annual household income to be between $20,000 and $40,000, 58 per cent believed the average income of all households lay within that range.

For those on $40,000 to $60,000, 71 per cent thought this was average. For $60,000 to $80,000 it was 61 per cent, for $80,000 to $100,000 it was 55 per cent, and for $100,000 to $150,000 it was 51 per cent.

Even for those on more than $150,000 a year, a third of them thought that was average. According to the Australian Bureau of Statistics, the average household income in Australia is $80,700.

But how could so many of us be so out of touch? How could we be so unaware of how the other half lives and which half we fit into?

I'm sure there are various reasons, but one of the big ones is something that's been going on for years without most of us noticing. Our cities are becoming more socially stratified, with the better-off congregating down one end and the less well-off down the other.

These days, you're less and less likely to find suburbs with a cross-section of high and low income-earners, or highly and lowly educated people.

So we don't know how the other half lives because they are in the other half - the half we live far away from and rarely visit or even drive past. Pretty much all our family, friends and workmates are in the same half we're in.

A study conducted last year by Jane-Frances Kelly and Peter Mares, of the Grattan Institute, Productive Cities, looked at maps of who lives where in Australia's largest cities and tracked how this had changed in the 20 years between 1991 and 2011.

The authors found that the residents of our four biggest cities have enjoyed rising incomes and have become much better qualified. At the same time, however, our cities had become more polarised.

"Increasingly, high-income residents with university-level qualifications cluster in suburbs close to city centres, while residents on lower incomes, and residents with vocational [trade certificate and diploma] qualifications, are more likely to live around the city fringes," they say.

"In each city, it is also possible to identify particular areas of disadvantage, where a high proportion of residents have no formal qualifications beyond secondary school, where labour market participation is low and where a high proportion of young people are 'disconnected' - that is, neither working nor engaged in education or training."

In Sydney and Melbourne, individuals on higher incomes are clustered in inner suburbs and suburbs with desirable natural attributes such as beaches, trees and hills.

In Sydney, the highest median incomes are found in inner, northern and harbourside and beachside suburbs, while the lowest median incomes are concentrated in western and south-western suburbs more distant from the CBD.

In Melbourne, the highest median incomes are found in inner, eastern and bayside suburbs, while the lowest median incomes are concentrated in more distant western, northern and south-eastern suburbs.

A map also shows a clear pattern in house prices. "The premium placed on proximity to the city centre is evident in steep house-price gradients in Sydney, Melbourne, Brisbane and Perth," they say.

Research by the Reserve Bank shows that, if you rank house prices for any of those cities according to their distance from the central business district, you get an almost perfect curve that (using figures from 2010) starts well above $1 million in Melbourne and Sydney and then declines steadily to about $300,000 when you're more than 60 kilometres from the centre.

This relationship between proximity and house prices has strengthened in recent decades, with average annual growth in house prices about 2 per cent higher in inner suburbs within five kilometres of the centre than on city fringes.

Those people out in the boondocks have no idea how much we struggle with our mortgages - and we have no idea that they have problems too. Price of petrol, for starters.

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Mining boom makes little sense

Conventional economic analysis assumes the behaviour of businesses is always rational but, in reality, the booms and busts that cause the ups and downs of the business cycle are driven by emotion more than rational calculation: unwarranted optimism, greed, impatience, short-sightedness and herd behaviour. Consider our resources boom.

The ideology of economic rationalism says private enterprise can do no wrong; ill-advised behaviour by business arises only through its rational response to distorted incentives created by the misguided interventions of governments.

This confers on the demands made by business a sanctity the captains of industry are quick to exploit. But their demands often aren't in the community's wider interest.

Now we're emerging from the decade-long resources boom it's easier to view the process with greater insight and make a more sober assessment of its costs and benefits.

What happened was a huge jump in the world prices of coal and iron ore as China's period of rapid economic development of heavy industry and infrastructure caused global demand to outstrip global supply.

The surge in China's demand caught the world's mining industry unprepared.

Like miners in other countries, our largely foreign-owned miners lapped up the huge increase in prices and profits.

But it didn't take long for greed ("the profit motive", if you prefer) and the irrational optimism that drives the world's entrepreneurs to take over, with companies seeking to exploit the high prices to the full by expanding their production capacity as much as possible as fast as possible.

What then kicked off was a multibillion-dollar race - between rival companies in a country, but also with the many companies in other countries, all expanding their capacity as fast as they could.

It takes a long time to build new mines and bring them into production. So the chances of your mine being completed in time to enjoy the super-high prices aren't great - the more so because it's essentially a self-defeating process: the more companies join the race and the harder they try to be among the first to complete, the sooner supply catches up with demand and prices start falling.

If mining companies were more rational, fewer would join the race. But companies are just as subject to herd behaviour as investors in a booming sharemarket. A mining chief who didn't join the comp would be subject to heavy criticism.

This is where the irrational optimism comes in. Each individual entrepreneur is in no doubt he'll be among the race's winners. We're gonna make a motza.

But while the miners are busy gearing up, their foreign customers are just as likely to be coming towards the end of their own boom in investment and construction. The inevitable result is that the global mining industry moves from a starting point of undercapacity to an end point of overcapacity.

This is the eternal story of mining. Only in passing is it ever in equilibrium; it's almost always in either under or oversupply - probably spending a lot more time over than under, the less profitable of the two conditions.

Now, this cycle isn't news to conventional economics, with its familiar "cobweb theorem" and "hog cycle" seeking to explain the phenomenon. But these models put too much of the blame on the unavoidable delays in increasing production, and too little on animal spirits.

And they don't prepare us for all the waste and inefficiency involved in a resources boom. In the miners' race to be first in and best dressed they compete furiously for resources, bidding up hugely the prices of labour, equipment and materials, and ending up with mines that cost them far too much to build.

They also develop lower-grade mineral deposits, the exploitation of which becomes uneconomic as soon as the world price drops back from its record heights.

In the aftermath of the boom, many acquisitions are written off, the chief executives who presided over these excesses get the chop and are replaced by bosses whose main skill is cost-cutting. They make speeches about how excessive Australian wages are.

Anyone who has followed the fortunes of our big three - BHP Billiton, Rio Tinto and Glencore Xstrata - will know just what I'm talking about.

In their race-driven frenzy to start new projects, the miners always portray themselves as impatient for God's will to prevail, with any politicians or community members who have doubts about allowing them to rip up the environment denounced as agents of the anti-progress devil.

In the aftermath of such booms we realise we should have refused to be rushed. Why does no economist ever warn us to be less short-sighted? Their faulty model.

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Many reasons for the impossible: power demand falling

We know the two great certainties in life are death and taxes, but many thought there was a third: the inexorable rise in consumption of electricity. As the population grew and each of us got a little more prosperous each year, we'd use more power. The mighty electricity industry was built on that certainty.

Except that electricity consumption has been falling for the past four years. To say this has taken the industry by surprise is an understatement. For well over a century – even during the Great Depression – the quantity of electricity used in Australia each year was greater than the year before.

It took the industry and its regulators two or three years to accept the trend was more than just a hiccup on the ever-upward path, which delay probably added to the decline.

There are few aspects of the economy – global or national – where change is more significant, more diverse or more interesting than energy supply and demand – where energy covers coal, gas (conventional and unconventional), petroleum, wind, solar and other renewables. Expect to hear more from me on the topic.

But there are few questions more interesting than exactly why the unthinkable, a fall in electricity consumption, has come about. Short answer: a surprisingly large combination of reasons, although Tony Abbott's crusading against the carbon tax must get some of the credit.

The best attempt to quantify the various factors involved comes from a report prepared by Dr Hugh Saddler, an energy expert with the Pitt and Sherry consultancy, for the Australia Institute. Saddler's modelling covers the years to 2012-13, but we know from reporting this week by Origin Energy and AGL that the fall continued in 2013-14.

Saddler focuses on energy produced and consumed from the National Energy Market, which covers the five eastern states and the ACT, but the decline is occurring also in Western Australia. After peaking in 2008-09, consumption from the national market in 2012-13 was down by almost 8 terawatt hours, or 4.3 per cent.

But that's only half the story. Just as important as why demand has fallen is why it hasn't continued growing, as continued growth in the population and the economy would lead us to expect. Saddler estimates that had demand continued growing from 2004 at its average rate of growth over the previous 20 years (2.5 per cent a year) it would have been 37 terawatt hours more than it actually was in 2012-13.

This shortfall is equal to the output of almost 5000 megawatts of coal-fired generation capacity, the combined capacity of the Bayswater and Eraring power stations in NSW, or Loy Yang A and B and Hazelwood in Victoria.

"All of the decline in consumption has been at the expense of coal-fired generators, with the result that many are now barely profitable," Saddler says.

Greenhouse gas emissions fell by 9.2 megatonnes of carbon dioxide equivalent, about 2 per cent of Australians total annual emissions.

So what has caused our power consumption to fall rather than rise? The biggest single reason is the introduction from the late 1990s of regulations to increase the energy efficiency of refrigerators, freezers and many other residential and commercial appliances, and to increase the energy efficiency of new buildings.

Saddler estimates this explains 37 per cent of the 37 terawatt-hour shortfall from what might have been.

The next biggest part of the explanation is structural change in the economy away from electricity-intensive industries. Over the year to September 2012, three major NSW industrial power users – Port Kembla steelworks, Kurri Kurri aluminium smelter and the Clyde oil refinery – were partly or completely shut down. This explains 10 per cent of the 37 terawatt-hour shortfall.

The evidence also suggests that power consumption by other major industrial users has been little changed over the three years to 2012-13. Saddler estimates that this failure to grow explains a further 14 per cent of the shortfall, taking the total contribution from structural change to almost a quarter.

The next most important part of the explanation is the response of electricity users, particularly residential users, to the higher prices they were being charged. Saddler finds that after 2010 there was "an abrupt change in consumer responsiveness to higher prices".

This was the time when the possible effect of a carbon tax on electricity became a major political issue thanks to the efforts of Abbott and his "sceptic" mates. At the time, retail electricity prices were rising spectacularly, mainly because of a huge increase in spending on upgrading the transmission and distribution networks (poles and wires) to cope with an expected ever-rising peak demand on hot summer afternoons.

Saddler finds evidence to support his argument that all this carbon-tax-related fuss about the high cost of electricity caused many households to be a lot more conscious of what was happening to their power bills and to respond by finding ways to cut their usage – to the extent that they "have managed to completely offset the effect of higher prices on their household budgets by reducing consumption".

This highly unusual jump in the short-run "price elasticity" of electricity explains 19 per cent of the shortfall, he estimates.

He further calculates that the growth in output from rooftop photovoltaic solar and other small, distributed generators accounts for about 13 per cent of the shortfall. This, of course, is a fall in the demand for electricity supplied by the major, mainly coal-fired generators, not a fall in the use of electricity as such.

Saddler notes that for the past three years the annual peak demand has been falling, not increasing, despite the huge investment to cope with ever-rising peaks. When will this additional capacity, which is now built and for which all electricity consumers are paying – and will continue to pay for some years to come – be required, if ever, he asks.

Good question.

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CARING ABOUT FAIRNESS

Talk to Legal Aid Conference, Sydney, Friday, August 22, 2014

I’m trying to give fewer speeches these days, and I knock back far more invitations than I accept, but I agreed to talk to you today mainly because I felt I ought to thank you. Thank you for the work you’re doing, for the contribution you make in ensuring that people are informed about their rights and responsibilities under the law and are adequately represented before the courts.

All of us are entitled to equal treatment under the law regardless of our means, but you don’t need me to tell you that, in a market economy such as ours, legal expertise is expensive, thus producing a big disparity between theory and practice in the dispensation of justice. Legal aid seeks to reduce that contradiction, but the inadequacy of its financing leaves many practitioners feeling they need to make a personal contribution.

I hope and expect the work you do brings you a lot of satisfaction - a lot of psychic income, as economists sometimes say - but, even so, I know that whether you’re working pro bono, whether you’re paid some quite inadequate government fee or whether you’re a full time government employee, all of you are making an actual-money sacrifice. The opportunity cost of your contribution is high.

The role of legal aid lawyers came into my mind when I was thinking about the wider implications of the Abbott government’s proposed changes to university funding. If the deregulation of fees led to very much higher fees for law students - as it almost certainly would - new graduates would be highly conscious of the huge debt they owed. And, assuming the plan to charge a ‘real’ interest rate on the debt goes ahead, highly conscious of the way the debt was being added to for as long it took to pay it off. The risk is this could make them a lot more mercenary in their choice of a career, more inclined to seek a high-paying job rather than a possibly more satisfying but less well paid job at a community law centre or in legal aid. It would be a similar story in medicine, with more young graduates anxious to get into high-paying specialties and fewer interested in the slog of general practice. Would this be a good thing? It would certainly be an ‘unintended consequence’.

Since we’re on the subject, and I’m sure it’s a topic of interest to most of you, let me use the rest of my time to examine it. Many people oppose the government’s proposed changes as ‘unfair’, but I think in this case the question of what’s fair and what’s not is much harder to determine that than.

When the Hawke-Keating government reintroduced uni fees - HECS, the higher education contribution scheme - the rationale was that, even though there is a public benefit from having a better educated, more highly skilled workforce, graduates gain a considerable private benefit from the acquisition of a degree - one worth, on average, a total of maybe three-quarters to a million dollars in higher salary over their working life. That being so, it was fair to other, non-graduate taxpayers to ask graduates to make a significant contribution towards the cost of their education. They’d still be way ahead on the deal.

The one big worry was that making graduates contribute to the cost of their education, and acquire a debt to the government, might deter bright young people from poor families from seeking to advance themselves. Professor Bruce Chapman, of the ANU, sought to overcome this problem by inventing the ‘income-contingent loan’, where the government effectively lends students their tuition fees, but students don’t have to begin repaying their loan until their income reaches a certain threshold. From that point, the tax office imposes a repayment of a certain small proportion of their income, with the proportion rising as their salary rises. Once a year the balance outstanding is indexed by the inflation rate. To an economist, this means the loan is subject to a real interest of zero. Because this interest rate is so concessional, and because repayments are geared to the debtor’s ability to pay and the level of repayments is never onerous, the fact that a student came from poor family shouldn’t deter them from going to uni. In Chapman’s mind, HECS is an equity (fairness) measure, intended to give students from poor families equal opportunity to go to uni.

The Howard government increased these fees some years later and also introduced three categories of fees, high, medium and low. This new fee structure was a hybrid one, based partly on recovering the cost of providing the degree and party on the amount of income a holder of that particular degree was likely to earn. The medicos went into the top category because medical education is expensive to provide. Law degrees are reasonably cheap to provide - no laboratories - but they also went into the most expensive fee category on the basis that lawyers earnt a lot of money. You probably know that; I mention it because, if the deregulation of uni fees leads to much higher fees for law degrees, it wouldn’t be hard for law students to be charged fees well in excess of their degree’s actual cost of provision. Would this be fair?

To analyse the fairness of the Abbott government’s proposed changes, we need to distinguish between the changes to the HECS loan-repayment scheme and the deregulation of fees. The main change on the HECS side is the plan to impose a real interest rate, based on the long-term government bond rate. Here Chapman has done some modelling which leads him to conclude the change would make HECS quite unfair, in that graduates who go into lower-paying occupations would end up paying much more interest than those who go into higher-paying occupations, simply because it took the less-well-paid much longer to pay off their debt. This would also apply to graduates whose full-time career was interrupted by childcare responsibilities or overseas travel. And it would apply particularly to students who spent a few years at uni before giving up and taking a non-graduate job. Of course, those graduates who went on to a high starting salary with quick progression to higher salaries - such as lawyers, doctors and others - wouldn’t be greatly burdened by the real interest rate because they’d pay back their loan so much quicker.

Even so, there seems little doubt the plan to impose a real interest rate on HECS would be significantly unfair. But judging whether fee deregulation would be unfair is trickier. Indeed, you could argue that requiring those who aspire to be among the highest income-earners - the great majority of whom come already from reasonably privileged homes - to pay a higher proportion of the cost of the education that makes this possible would make the system fairer rather than less fair.

No, my reservations about fee deregulation don’t arise from a concern about ‘fairness’ in the conventional, distribution-of-income sense. For many years federal governments have been involved in a process of back-door privatisation of our universities. It’s clear the motive for this is primarily financial: to reduce tertiary education’s call on the federal budget. Before the process started, unis relied on the federal government for about 80 per cent of their funding. Today’s it’s down to about 40 per cent. The primary motive of fee deregulation is to create greater scope to continue this process, maybe eventually getting the unis off the books completely.

It’s significant that the decision to allow unis to set their own fees comes with a cut in federal per-student grants to the universities averaging 20 per cent. I have no doubt that, should fee deregulation go as planned, the government’s intention is to further cut its per-student grants. It probably also intends to push more of the burden of funding university research back on to the unis themselves and, through them, on to students via ever-higher fees. This seems clear from the government’s rhetoric linking fee deregulation with raising the international ranking of our top unis.

When I say successive governments have been quietly privatising our unis, I don’t mean they’d like eventually to see them as privately owned businesses. But it’s clear the goal is to make them non-government, non-profit organisations competing with each other in a tertiary education market. Unis are to be the next be step in the ‘marketisation’ of Australian life. Canberra’s primary motivation is to free its budget of the burden of the unis, but this motive is bolstered by its ideological conviction that the discipline of the market would drive out all the inefficiency in universities that every academic complains of, and leave us all much better off.

But this is where I hae me doots. Economists love markets, and most economic rationalists think the more aspects of our lives that are subject to the discipline of market forces, the better off we are. It is, of course, a more materialist approach to life, where we think more about money and self-interest and less about our contribution to the good of society and the wellbeing of others, where we’re more individualistic and less communitarian, where young lawyers are more likely to go for the big bucks and less likely to do a sappy thing like getting involved in legal aid. I don’t like the sound of it.

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Abbott's economic script is out of date

It doesn't seem yet to have dawned on Tony Abbott that he was elected because he wasn't Julia Gillard or Kevin Rudd, not because voters thought it was time we made a lurch to the Right.

The man who imagines he has a "mandate" to mistreat the children of boat people, ensure free speech for bigots, give top appointments to big business mates and reintroduce knights and dames, represented himself as a harmless populist before the election.

The other thing he doesn't seem to have realised is that just as he has us moving to reduce our commitment to action against climate change and to make the budget much less fair, the rest of the advanced economies are moving the opposite way.

President Obama is taking steps to overcome Congress's refusal to act on global warming, the Chinese get more concerned about it as each month passes and the International Monetary Fund is chastising us for our apostasy.

And while we use our budget to widen the gap between rich and poor, people in other countries are realising the need to narrow it.

Wayne Swan, former Labor treasurer, noted in a speech on Monday that "centre-right political leaders across the globe are acknowledging the obvious truth that capitalism is facing an existential challenge ... only last week ratings agency Standard and Poor's emphasised yet again that high inequality is a drag on growth".

In Australia, however, an increasing "vocal minority has decided to oppose any reform, no matter how necessary and no matter how obvious in its benefits to the whole nation, if they perceive it is in their short-term interests to do so".

"This is a recipe for unnecessary political division and widening social inequality, and unfortunately permanent reform failure," he says.

Australians had done much better than the Americans at matching strong economic growth with social equity but, according to Swan, "we're witnessing the Americanisation of the Right in this country. Obsessed with defending the advantages of the wealthiest in our society".

In his efforts to defend rather than correct his first budget's unfairness, Joe Hockey seems to be doing just that. Meanwhile, the messages from international authorities are very different.

In a recent paper on policy challenges for the next 50 years, the Organisation for Economic Co-operation and Development warned the growing importance of skill-biased technological progress and the rising demand for skills, will continue to widen the gap between high and low wages.

Unless this was corrected by greater redistribution of income, other OECD countries would end up facing almost the same level of inequality as seen in the US today. "Rising inequalities may backlash on growth, notably if they reduce economic opportunities available to low-income talented individuals," it warns.

Christine Lagarde, managing director of the International Monetary Fund, noted in a speech that the 85 richest people in the world control as much wealth as the poorest half of the global population - 3.5 billion people.

"With facts like these, it is no wonder that rising inequality has risen to the top of the agenda - not only among groups normally focused on social justice, but also increasingly among politicians, central bankers and business leaders," she said.

"Many would argue, however, that we should ultimately care about equality of opportunity, not equality of outcome." As it happens, Hockey has defended his budget's unfairness with just that argument.

"The problem is that opportunities are not equal. Money will always buy better-quality education and health care, for example. But due to current levels of inequality, too many people in too many countries have only the most basic access to these services, if at all. The evidence also shows that social mobility is more stunted in less equal societies."

Disparity also brings division. "The principles of solidarity and reciprocity that bind societies together are more likely to erode in excessively unequal societies. History also teaches us that democracy begins to fray at the edges once political battles separate the haves against the have-nots."

Pope Francis put this in stark terms when he called increasing inequality "the root of social evil".

"It is therefore not surprising that IMF research - which looked at 173 countries over the past 50 years - found that more unequal countries tend to have lower and less durable economic growth," Legarde said.

Get that? Until now, the conventional wisdom among economists has been that efforts to reduce inequality come at the expense of economic growth. Now a pillar of economic orthodoxy, the IMF, has found it works the other way round: rising inequality seems to lead to slower growth.

Lagarde said other IMF research had found that, in general, budgetary policies had a good record of reducing social disparities. Social security benefits and income taxes "have been able to reduce inequality by about a third, on average, among the advanced economies".

What can we do? "Some potentially beneficial options can include making income tax systems more progressive without being excessive; making greater use of property taxes; expanding access to education and health; and relying more on active labour market programs and in-work social benefits."

Perhaps in his efforts to get a modified version of his budget passed by the Senate, Hockey could bring in the IMF as consultants.

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Stop wasting money on infrastructure

Don't laugh too hard at the ABC's new satire, Utopia, and the wasteful and appearances-driven antics Rob Sitch gets up to as head of the Nation Building Authority. It's too close to the truth to be funny.

One of the foremost areas where governments need to lift the efficiency of their spending - as opposed to cutting payments to the needy or short-sighted cost-shifting - is infrastructure. It has become an area where too much spending is never enough and anything labelled "infrastructure" is above critical scrutiny.

In recent days, however, we've been given cause to cast a more sceptical eye over spending on capital works. Consider first the views of a highly experienced former econocrat, Dr Mike Keating: "Australia has a long history of over-investment in infrastructure, with the costs exceeding the benefits, and under-charging the beneficiaries so that they demand more and more.

"It is therefore most reprehensible that this budget prides itself that new spending decisions will add $58 billion to total infrastructure investment, when none of the projects announced have been ticked off by Infrastructure Australia as having completed proper cost-benefit appraisals, probably because a great deal of this investment never could pass any proper evaluation.

"And this from a government that was properly critical of the former government and its approach to the national broadband network. Clearly this improper use of the nation's savings is not an acceptable reason for the other budget cuts, and the increase in petrol excise should not be tied to an increase in uneconomic road funding."

Yes, indeed. It's disillusioning behaviour from Tony Abbott, who promised "rigorous, published, cost-benefit analysis" of infrastructure projects.

Last week, Garry Bowditch, chief executive of the University of Wollongong's SMART infrastructure facility, offered a sobering assessment of capital works spending, noting that cost overruns have reached between $4 billion and $5 billion a year.

Value for money is thrown out the window, he said, when governments fail to time the construction of infrastructure to make sure they're not inflating the prices of labour, materials and equipment by competing with the private sector during booms.

Adjusted for inflation, Brisbane's Gateway Bridge, built in 1986, cost about $300 million. But when a second, identical bridge was built in 2010, during the mining construction boom, it cost $1.7 billion.

Bowditch, a former econocrat, called on governments to release cost-benefit analyses for Sydney's proposed $11.5 billion WestConnex motorway and Melbourne's $8 billion East West Link tunnel.

He argued that poor long-term planning by federal and state governments, which don't communicate well with each other, had led to unnecessary costly construction methods, such as tunnels, because land corridors had not been reserved for rail and road development.

Sir John Armitt, former chairman of Britain's Olympic Delivery Authority, said we should be using technology to improve the capacity of existing rail, road and energy networks, and to prepare for driverless cars.

Good point. Politicians love cutting ribbons and announcing grand, nation-building projects. But they'd waste less taxpayers' money if they got the pricing of existing infrastructure right first, and so had a more realistic estimate of the demand for additional infrastructure. It's called efficiency.

The credibility of economic modelling by allegedly independent consultants is surely shrinking before our eyes. Not long ago we were treated to the spectacle of two leading firms of economic consultants producing diametrically opposed modelling of the cost of the renewable energy target. Why? Surely not because they were commissioned by outfits with rival axes to grind?

Last week we learnt that AMP, whose funds lost a lot of dough after the failure of the outfit owning Sydney's Lane Cove Tunnel in 2007, is suing the consultants who provided excessive forecasts of the likely traffic flows, accusing them of producing figures that were "reverse engineered" by working backward from their client's commercial objective. Surely not.

One reason it would be good to see cost-benefit analyses of the aforementioned infrastructure projects adopted by the Coalition is to test the efficiency of Abbott's insistence that he'll finance roads but not public transport.

So far the NSW and Victorian governments have done a hopeless job of limiting congestion. Since building extra motorways adds to demand rather than reducing delays, my guess is neglect of public transport is the culprit.

But the Grattan Institute's report on cities as engines of prosperity reminds us that the longer it takes people to move between home and job, the harder it is to fully exploit the "knowledge spillovers" that drive the knowledge economy. Didn't you guys say you were worried about slow productivity improvement?

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TALK TO TREASURY SEMINAR ON COMMUNICATING ECONOMIC IDEAS

National Library of Australia, Canberra

As far as journalism is concerned, economics is the great contradiction. On the one hand, there’s no subject more like to get you a guernsey on the front page. On the other, there’s no subject more likely to confuse, irritate or simply bore the reader rigid.

If economics is the study of the ordinary business of life, and GNP is what ensues when 86 million Americans get up and go to work, it has the potential to be a subject of great interest to most people. The trouble is that economics turns out to be a highly conceptual, abstract, analytical subject, which is what gives it so much potential for incomprehension.

If Treasury cares about economic outcomes - not just going through the proper process - it also needs to care about communicating its messages effectively to its ‘stakeholders’ - the minister, the minister’s staff, other cabinet ministers, journalists, the financial markets and business people, and the public. The voting public is the ultimate stakeholder in any democracy - as your political masters are well aware - but, though your speeches and publications go up on your website for any punter to see, the vast majority of your communication with the public will reach the public only through intermediaries - at one level, your minister and the government; at another level, the media. As a journalist I think of myself as a retailer of economic information, and Treasury, the Reserve and other official sources as wholesalers of that information. My job is to take what the wholesaler supplies, break it down into palatable portions - often, translate it into simple English - and repackage it for sale to our readers. But the less translation required, the more retailers will want to sell your message, the bigger the audience will be and the lower the risk of mistranslation. In other words, leaving it to others to do the hard yakka of communication isn’t the best strategy.

Treasury offers advice to its political masters, but it needs to be sure the nature of that advice is clearly understood, and also the reasons why one course of action is considered superior to another. It may well be the minister’s staff are the people who need to be convinced before the minister is. But once he or she is on board, they’ll need to convince their cabinet colleagues to agree, after which the minister, prime minister and the whole government will need to convince the public that this is the right policy for Australia. Since we’re dealing with a long chain of convincing, my advice is to begin the convincing job right from the start. A big part of making a sale is actually convincing the person at each link in the chain that it will be possible to convince the next person. The eye of each person in the chain will be on the final link in the chain of convincing: will we be able to convince the punters this is the right way to go? In other words, although you might use additional arguments with the treasurer, the way you explain the basic arguments - the level of complexity - should be much the same as the treasurer will be using to ‘sell’ the policy to the public.

Let me mention just a few of the fundamentals of effective communication. Step one is to think hard about your intended audience: who are they, how interested are they in your topic, how much do they already know about the economics of the topic and, putting yourself in the audience’s shoes, what’s their likely perspective on the policy, their starting-point, biases and preconceptions?

On your audience’s correct level of assumed knowledge, I can tell you now: lower than any economist is likely to imagine. My advice is to use a similar assumption to the one I use: an intelligent, educated audience that knows a lot about some subject, but not economics. You have to avoid trying to impress people with enormity of your own knowledge by using economic jargon and big words generally, and avoid what the psychologists call ‘the curse of knowledge’ - assuming that if you know about it, everyone else does too. And avoid worrying about offending people’s intelligence. This is one of the big reasons why people find economists so hard to understand. Why so? Because the way you construct an argument is to proceed from what’s known and agreed to what’s unknown and contentious. When economists avoid stating the obvious they’re often avoiding stating the premise of their argument; then they wonder why people can’t follow their argument. The other thing economists don’t understand is that people like being told what they already know because they find it reinforcing. You can always excuse a statement of the obvious by saying ‘of course’, or ‘as we know’.

Writing that communicates well needs to be a clear and simple. You do this by avoiding excessive formality - in my writing I try to mimic conversation; by finding the line between simple and simplistic; by writing in the active voice (subject, verb, object; A did B) rather than the passive voice beloved of bureaucrats (object, verb, subject; B was done by A); and by always preferring a short word to a long one, using a mixture of sentence lengths with a lot of short ones, and avoiding professional shorthand.

Economists speak to each other in shorthand because they all know a lot about the topic and leaving out a word or two saves time. As well, economists aren’t averse to the academics’ vice of trying to sound profound by deliberately making what they say hard to understand. But leaving out words can be a great barrier to understanding by the uninitiated. Refer to the ‘money supply’, for instance, and some people aren’t sure what you mean. But adding just one, two-letter word can produce a flash of comprehension: the ‘supply of money’. Not impressed? Try this one: ‘lower output growth volatility’ is more readily comprehended if turned into ‘lower volatility in the growth of output’.

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Economists should learn some geography

One of the great failings of economists is their confident assumption that their way of looking at the economy is the only way - certainly, the only useful way - of understanding it.

For one thing, their almost exclusive focus on money - prices, actually - and their convenient assumption that people are rational, allows them to analyse an economy populated by automatons rather than fallible, flighty humans.

Behavioural economics and economic sociology attempt to correct this deficiency.

But there's another way of studying the economy that most economists take little interest in, to the detriment of their understanding of how the economy ticks: its spatial dimension. This failure is getting more costly as we move to a knowledge economy.

Why isn't economic activity spread pretty much evenly across our vast continent? Why is almost all of it concentrated around our coastline?

For most of our states, up to three-quarters of their economic activity is concentrated in their capital city, which is also the state's first site of white settlement. This is partly an accident of history. Newcomers tend to settle where other people are already settled.

But economic geographers have long known there's also a lot of economic logic to where people settle. Farmers tend to settle where the most arable land is. Mines have to be built where the minerals are.

Manufacturers have to decide whether to build their factories close to where their raw materials are or close to where their customers are. They usually decide to set up in cities, often on the outskirts of cities where land is cheaper.

What's more, many of the firms in a particular industry will gravitate to the same city, usually a big one. Why? So as to exploit "economies of agglomeration".

You've heard of economies of scale. Economies arise when similar firms agglomerate (cluster together). Workers with skills relevant to that industry are attracted to that city, meaning firms have less trouble getting the skilled workers they need. Workers who lose their jobs at one firm may not need to move house to get another job at a similar firm.

Likewise, the manufacturers and their suppliers of specialist equipment and materials each benefit by being close to each other. Firms in the same business can keep an eye on each other, copying anyone who gets on to a better way of doing things. That way, the whole industry gets more efficient at a faster rate.

All this has long been understood by economic geographers. But the advent of the knowledge economy has given agglomeration economies a major new twist and added to the economic significance of big cities, as the report, Mapping Australia's Economy: cities as engines of prosperity, by Jane-Frances Kelly and Paul Donegan, of the Grattan Institute, has pointed out.

"Today the Australian economy is no longer driven by what we make - the extraction and production of physical goods - but rather by what we know and do. Like other advanced economies around the world, our economy is continuing to become more knowledge-intensive, more specialised and more globally connected," the report says.

"Knowledge-intensive businesses - which are the most productive today - tend to cluster and thrive in the centres of large cities."

It turns out economic activity in Australia is concentrated in and around large cities, but is not distributed evenly within cities. Central business districts and inner-city areas are especially important: they represent substantial concentrations of employment, but even more intense concentrations of economic activity. In other words, CBD workers have a lot higher productivity than other workers.

The report explains that "the more highly skilled and specialised a job, the greater the need to find the best person to fill it. This is especially important when the work involves knowledge, expertise, judgment and learning".

Being close to suppliers, customers and rivals helps businesses generate new business opportunities and ideas for products and services, and better ways of working. These transfers of expertise, new ideas and process improvements that occur through interactions between businesses are called "knowledge spillovers" (a class of "positive externality").

Within cities, CBDs and inner-city areas offer the most opportunities for face-to-face contact among workers, essential to benefiting from knowledge spillovers. Spillovers often involve combining and recombining knowledge to come up with new products and ways of working.

Workers build on each other's thoughts, jointly solve problems and break through impasses. Trust is essential, and these kinds of complex conversations are best had in person.

"High-speed broadband and other advances in communication technologies will never replace the importance of face-to-face contact," we're told.

Grattan's research finds that residential patterns and transport systems mean CBD employers have access to only a limited proportion of workers in metropolitan areas. Turning that around, many workers, particularly in outer suburbs, have access to only a small proportion of jobs across the city.

For instance, in some outer suburban growth areas of Melbourne, just 10 per cent of the city's jobs can be reached within a 45-minute drive. If work journeys are made by public transport it's worse.

The report warns that, unless governments lift their game, "Australian cities are likely to continue to spread outwards, further increasing the distance between where many people live and the most productive parts of large cities". This would harm productivity - and workers' opportunity to get ahead.

The point is, governments need to understand the economy's spatial dimension and respond by ensuring transport networks better connect employees with employers, and businesses with their customers and suppliers. Continue letting congestion worsen and you cause productivity to be lower than otherwise, not to mention adding misery to people's lives.

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Big business now calling the economic shots

Sometimes I wonder whether the economy is being managed for our benefit or for the benefit of the big businesses that dominate it. The two big supermarket chains we get to choose between, the two domestic airlines and privately owned airports, the three foreign mining giants that were allowed to redesign the mining tax they didn't like, and the four big banks that control so much of our superannuation and the investment advice we get, not to mention our savings accounts and mortgages.

I'm old enough to remember when economic life seemed to be dominated by big unions. Hardly a month passed without our lives being disrupted by some strike. We'd be walking miles to work or finding someone to mind the kids while the teachers were out.

I remember finishing a holiday in New Zealand with our young family, only to find the baggage handlers in Sydney were on strike and being stuck in Christchurch for an extra two days.

Thank goodness we don't have to put up with all that any more. But in place of being bossed around by the unions, we now have big business calling the shots. They don't inconvenience us like the unions did, but they do seem to have the ear of government.

Big business is always complaining about some way the economy's being run that doesn't meet with its approval. It's always warning of the terrible economic price we'll pay if it doesn't get what it wants. Its complaints are always treated with reverence by the media. And always taken seriously by the government, Labor or Coalition.

We seem to be developing a new economic religion that what's good for big business is good for the country. No one believes this more fervently than the big business people themselves - plus their never-silent lobby groups.

These paragons of industry want to be unfettered in their efforts to expand their businesses and make higher profits, which they're doing purely in the interests of you and me. And they're always terribly impatient. They want to frack wherever they want to frack, they want to start tomorrow and they don't want selfish, short-sighted people to slow them down, let alone stop them.

They want to invest in a new mine or a new something which will create tens of thousands of new jobs in the district, and what other consideration could possibly trump that? If you want to consult the locals before granting permission, this is "red tape", which by definition is bad and must be swept aside. If you want time to investigate the environmental impact of the project, this is "green tape" and just as much economic vandalism as the red.

Another problem is the breakdown of "caveat emptor" - it's the buyer's job to make sure they're not ripped off. Products, particularly financial products, have become complex and hard to compare - deliberately so, you have to suspect.

In theory, we're supposed to read every word of the contracts we sign, know whether the nice man giving us advice on our savings is being paid to push some products but not others, know whether he'll go on receiving a commission for years without contacting us again, check continually to see whether our bank is now offering a better deal than we get without telling us or whether we should be moving our banking business, check what fees we're being charged on our superannuation and whether a different fund would give us a better deal.

In theory, we should devote much of our free time to doing all that. In practice, few do. We like to relax when we're not working and are diverted by an ever-multiplying range of commercial entertainments.

In practice, big business knows far more about this stuff than we do. So we need governments to protect us from being exploited, prohibiting certain kinds of behaviour, requiring financial institutions to keep us informed in ways we can understand and not take advantage of our inferior knowledge and inertia.

After many people lost their savings during the financial crisis, the previous federal government decided to tighten up on financial advice. Its original plans were modified after lobbying by the banks and their lobby groups, and now they've been watered down further by the present government - all in the name of reducing red tape.

The government compels most employees to contribute 9.5 per cent of their salaries to superannuation, from which the people running those funds extract very high fees - now equal to an amazing 1 per cent of gross domestic product - which greatly reduce final payouts.

The interim report of the inquiry into the financial system found that the fees appeared high by international standards. It found little evidence of strong fee-based competition between funds. The funds have got a lot bigger in recent years, but these economies of scale haven't led to lower fees.

The previous government introduced a new, simpler super account called MySuper in an effort to reduce fees, but the report says it's too early to assess its success in doing so. Last week, the Financial Services Council lobby group began arguing strongly that fees aren't too high. We must hope it isn't as influential in resisting the push for lower super fees as it was in getting the investment-advice protections watered down.

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ALL YOU NEED TO KNOW ON THE TRICKY TOPIC OF PRODUCTIVITY

Talk to VCTA Teachers Day, Melbourne, Monday, August 11, 2014

Productivity isn’t everything, but in the long run it is almost everything. A country’s ability to improve its standard of living over time depends almost entirely on its ability to raise its output per worker.

                                                                     Paul Krugman, The Age of Diminishing Expectations (1994)

There are few economic topics more important than productivity improvement, or more often in the news. The economic managers frequently express concern about our seemingly poor performance in recent years and about the slower rate of growth in income per person we are likely to experience following in the deterioration in our terms of trade, and the decline in labour force participation caused by population ageing, unless we greatly improve our productivity performance.

And yet productivity is a tricky topic. A lot of people who use the term don’t actually understand what it means. Some people think it’s just a fancy word for production, or that when economists say we need higher productivity they mean we should be working harder. A lot of business people think productivity and profitability are pretty much the same thing. And also that productivity improvement is something governments do for businesses by making changes that make business life easier, rather than something that emerges from the efforts of their own business to survive and prosper. And even a lot of economists view productivity through the prism of their economic model, advocating certain ways of improving it, but not others. So much of what businesspeople say about productivity is rent-seeking and much of what economists say is propaganda.

Productivity is tricky in another respect: like a lot of basic concepts in economics - such as the NAIRU or the cyclically-adjusted budget balance - it’s conceptually simple but very hard to measure in practice. And once you’ve arrived at a measure you have to be very careful how you interpret it. There are circumstances where an improvement in productivity can have bad causes and a deterioration can have good causes. There are other times when a deterioration may be illusory or nothing to worry about. And, because of limitations in both measurement and our understanding of the phenomenon, it’s common for us never to be sure exactly why it’s improved or deteriorated.

I want to make sure you’re up to speed on all the ins and outs of productivity. I’ll go into the topic more deeply than you would need to with your students, but it’s never a bad thing for you to know more about the topic than they do.

Definition

Productivity is the ratio of output produced to inputs used, or output per unit in input. Colloquially, it’s what you get out compared with what you put in, or it’s bang for your buck. It’s a measure of productive (or technical) efficiency, necessary but not sufficient to achieve allocative (economic) efficiency.

The simplest, most commonly used - and probably least inaccurately measured - measure is the productivity of labour. You take the quantity of goods and services produce during a period (real GDP) and divide it by the number of hours of labour required to achieve that production. But you can improve the productivity of labour simply by giving workers more machines to work with. And this tells us nothing about the efficiency with which the economy’s physical capital is being used. So in recent years it has become fashionable to focus on a more sophisticated measure called ‘multi-factor productivity’.

MFP (sometimes called total-factor productivity) is the growth in real GDP (output) that can’t be explained by any increase in inputs of both labour and physical capital. So, in principle, multi-factor productivity should arise primarily from ‘technological progress’ - the invention of better physical technology and the discovery of better ways to organise the production of goods and services. It’s technological advance that does most to raise material living standards.

But though MFP is often regarded as a proxy for technological advance, in truth it measures much more than this. In this era of the knowledge economy, it will also reflect increases in human capital (the skill, education and training of the workforce), which could be significant. As well, it will reflect economies of scale and scope, gains from specialisation, changes in capacity utilisation, changes in the composition of industry (if, for example, low-productivity industries are growing faster than high-productivity industries), and even weather events and water availability.

Importance

If you accept the prevalent view among economists that we need as much economic growth as we can get to achieve an ever-increasing material standard of living - as simply measured by real income per person - then, as Paul Krugman has said in his famous quote, in the long run, productivity is almost everything. It’s productivity improvement that does most to cause real income to grow faster than the population. (For both social and environmental reasons, I don’t share this prevalent view. For me, quality of life is a more important objective than standard of living.)

Over the past four decades, growth in the productivity of labour accounted for about 80 pc of the growth in Australians’ real income per person. The main way this was achieved was by giving workers more machines (physical capital) to work with. But 36 percentage points of the 80 came from MFP improvement.

Measurement

The first problem with measuring productivity is that it’s cyclical, varying with the economy’s degree of capacity utilisation. Productivity is likely to rise strongly as the economy recovers from a recession, but then slow as the economy reaches full employment. In the downswing, productivity is likely to worsen as firms lose sales but hang on to their workforce and use their capital equipment to produce fewer products. Then, when the economy begins to recover, and sales and production increase without any more labour and capital being used, productivity shoots up again.

Combine this cyclicality with the fact that the national accounts are so heavily revised and you see that little significance should be attached to quarter-to-quarter changes in productivity. Even annual changes should not be taken too literally. This explains why the Bureau of Statistics prefers to measure productivity as the average over a ‘productivity cycle’ between years when the degree of capacity utilisation is similar. The length of these cycles differ, but have averaged about five years. Because it take so long before another cycle is completed, the econocrats just rely on using averages over the past few years.

The second problem with measuring productivity is that when an industry’s output isn’t sold in a market it’s not possible to measure its productivity. When the activities of governments and government-dominated sectors are included in GDP the value of their output is assumed to be equal to the cost of their inputs. That is, their productivity never changes. For this reason the bureau also calculates productivity in the ‘market sector’ which is 16 of the 19 industry categories, excluding education, health and public administration. This market sector accounts for about 83 pc of GDP. The bureau also calculates figures for a 12-industry market sector - accounting for two-thirds of GDP - and this narrower definition is the one used by the Productivity Commission.

While GDP and total hours worked can be measured with reasonable accuracy, thus making labour productivity figures reasonably reliable, the same can’t be said for MFP. Measuring the volume of capital inputs - ‘units of capital services’ - is particularly difficult. In truth, it is based on a lot of assumptions, which may or may not hold, making the figures pretty ropey. The other major problem with MFP is that it’s measured as a residual, so can be distorted by mismeasurement of any or all of the other factors. One important cause of mismeasurement is changes in the quality of either inputs or outputs. Combine this measurement problem with all the many possible components of MFP and it’s hard to draw many confident conclusions from its ups and downs.

Scorecard

According to figures calculated by the Reserve Bank in a speech by Glenn Stevens in July 2014, the productivity of labour for the whole economy improved at the trend rate of 2.1 pc a year over the 14 years to 2004, but slowed to 0.9 pc a year in the six years to 2010, before accelerating to 2.0 pc a year over the three and a quarter years to March 2014. This implies that, whatever the problem was in the second half of the noughties, it seems to have gone away.

But the figures for MFP in the 12-industry market sector presented in the Productivity Commission’s latest annual productivity update show a much less reassuring picture. The long-term rate of MFP improvement between 1973-74 and 2012-13 has averaged 0.7 pc a year. Between 2003-04 and 2007-08, however, the improvement deteriorated to minus 0.1 pc a year, essentially, four years of zero improvement. And over the five years to 2012-13 MFP actually worsened by 0.6 pc a year.

This is a very different story to that told by the labour productivity figures, and the Productivity Commission regards it as very concerning. But it’s also very puzzling. It’s highly unusual for labour productivity to be improving while MFP deteriorates, and for this to continue for a decade. With something so dramatic, you’d expect the problem to be glaringly apparent. But nothing sticks out. The formerly common claim that the problem was the alleged ‘reregulation’ of the labour market under Labor’s Fair Work, simply doesn’t fit. The rot began years before the Fair Work changes took effect from the beginning of 2010, which was about when labour productivity started performing normally. In any case, you’d hardly expect a supposed worsening in industrial relations to fit with an improvement in labour productivity but a worsening in MFP. About the only factor big enough to be a suspect in explaining this strange behaviour is the resources boom.

Explaining the deterioration in MFP

The Productivity Commission has analysed the figures by industry and identified three industry sectors as doing most to explain the deterioration: mining, utilities (electricity, gas and water) and manufacturing. It has closely examined each of these industries and identified many factors that, between them, do much to explain the apparent deterioration. But almost all of them fall under the headings of temporary factors that will right themselves in due course, factors that have worsened productivity without themselves being bad, factors beyond our control, or the productivity cost of pursuing other desirable policy goals.

The primary reason for mining’s poor productivity performance, which does much to explain the poor performance overall, is well known: the industry has poured a lot of inputs into building new mines and natural gas facilities which have yet to come on line and start contributing to output. When they do, the industry’s performance will improve markedly. However, the high prices for coal and iron ore made it profitable for miners to begin mining lower-grade or hard-to-reach deposits that were formerly sub-economic. The mining of these marginal deposits will permanently lower the industry’s level of productivity (because more inputs are need to win a given quantity of output), but it is good, not bad, that higher prices have allowed us to exploit more of our natural endowment.

In the utilities sector, the productivity of water has been hit by drought (reduced capacity utilisation), by the decision to build and then mothball desalination plants in every state capital, and by the lasting effect of water-use efficiency measures in reducing demand for water (eg piping to prevent evaporation in irrigation; better shower heads). The productivity of electricity has been reduced by greatly increased investment in the natural monopoly distribution network (‘poles and wires’) to meet peak levels of demand and excessively levels of reliability, at a time when demand for electricity has been falling for various, mainly good reasons.

The three industries within manufacturing that do most to explain its poor productivity performance are petroleum and chemicals, food and beverages, and metal products. Petroleum and chemicals’ poor performance is explained mainly by increased investment by petroleum refineries to meet new environmental standards - ie an unmeasured quality improvement.  Metal products’ poor performance is explained partly by an expansion in alumina refining capacity which has yet to come on line. Food and beverages’ poor performance is partly explained by a change in consumers’ preferences in favour of products made in smaller-scale, more labour-intensive bakeries. Both petroleum and chemicals and metal products are suffering from reduced capacity utilisation rising from their loss of competitiveness caused by the high dollar.

The point of all this is that the startling MFP figures seem to have been produce by multitude of factors, many of which will correct themselves or are no cause for concern and some of which are beyond our control. That is, the commission’s analysis could identify ‘no overarching systemic reason for the decline’ and thus no problem or problems the government should be fixing, bar one: it’s clear defective price regulation in electricity is encouraging excessive investment in the distribution network.

In the light of all this, and remembering how prone MFP is to mismeasurement, I’m not persuaded we need to hit panic stations.

Bad productivity improvements and good productivity declines

Productivity is just a means to an end - the end of greater economic wellbeing - so it’s important not to treat it as an infallible indicator. Increases aren’t always good and decreases aren’t always bad; you need to examine the reasons for them. At the margin, labour and capital are substitutes in the production process. If wage rates get too high, firms may decide to invest in more labour-saving equipment. For the particular firm involved, this means fewer workers but the same or more output, leading to higher labour productivity. But is this a good thing if it has been caused by excessive wage rates? It’s the position that obtained during the Whitlam and Fraser years. After the Hawke government came to power in 1983 it used its accord with the ACTU to achieve a significant fall in real wages. The result was strong growth in employment and rapidly falling unemployment. But this also meant much weaker labour productivity improvement. Was this a bad thing?

Similarly, labour productivity is likely to deteriorate as an economy approaches full employment because employers are obliged to hire the remaining, less-qualified, less-productive workers. Does that make full employment a bad thing? And, as we’ve already seen, rising commodity prices encourage miners to exploit less attractive, harder-to-win mineral deposits. Is this bad?

Productivity, profits and wages

It’s important to remember that productivity is a ‘real’ concept. That is, it compares quantities, not prices or values - the quantity of output with the quantity of inputs. This is why productivity and profitability are quite different concepts. Because of this, it’s likely most firms don’t collect the data that would allow them to calculate changes in their productivity. And it’s arguable they don’t need to bother: their role is to pursue profits; what effect this has on the nation’s productivity is of no direct concern to them. All we know is that over the more than 200 years since the industrial revolution, firms’ pursuit of profits has led to almost continuous productivity improvement.

It’s less common these days, but you still hear employers arguing that wage rises can only be justified by the equivalent improvement in labour productivity. Wages settlements in excess of productivity growth will be inflationary. This is why it’s important to remember productivity is a ‘real’ concept. The employers are conveniently forgetting this. It’s only necessary for a rise in real wages to be justified by an equivalent increase in productivity. And only if real wages grow faster than productivity with this be inflationary.

This explains why the Reserve Bank’s unspoken ‘line in the sand’ for annual nominal wage growth is 4 pc: an inflation rate of 2.5 pc (mid-point of the inflation target) plus 1.5 pc for trend labour productivity growth. Only when nominal wage growth exceeds 4 pc is it likely to worsen inflation.

A point to note is that these are macro economy-wide figures. It’s neither necessary nor desirable that the real wage increases granted at each individual workplace be matched by productivity improvement at that workplace. This is the notion of ‘productivity bargaining’ which for a period of the Accord proved a useful device for encouraging unions to give up impractical demarcations and restrictive work practices, but provides no sound basis for continual bargaining at the enterprise level. This is because there are some firms with much scope for the removal of inefficiencies, but others with very little. Is it seriously suggested that workers at already-efficient firms receive no real wage rises? As well, there are high-productivity industries (usually those that are capital-intensive) and others than are low-productivity (often in the services sector). Should a clerk working in a high-productivity industry end up being paid a lot more than one in a low-productivity industry?

Fortunately, neither wage bargaining nor the labour market work like that. There are differences between the wages of workers with similar skills working in different industries, but they aren’t great - particularly when you remember than truck drivers in the Pilbara are being paid a special premium for working long hours at a remote and unpleasant location. In other words, workers in particular occupations are reasonably mobile between industries and so tend to be paid similar rates. Because workers’ wages don’t differ much according to the productivity of their industry, this operates as a mechanism by which improvements in national productivity are spread reasonably proportionately between labour and capital and reasonably proportionately between workers generally.

Productivity and employment

Especially when viewed from the perspective of particular industries or firms, efforts to improve productivity by automation and other labour-saving investments can be seen as job-destroying. This may seem true from a short-term, micro perspective, but it can’t be true economy-wide. It can’t be true because industries have been replacing men with machines for more than 200 years and the unemployment rate is only up to 6 pc, not 94 pc.

The explanation is simple: replacing workers with machines leads to increased productivity and increased productivity increases real income. The community is better off because outputs have increased relative to inputs. This increase in real income will be reflect in some combination of: higher profits for the owners of the business, higher wages for the remaining employees of the business or, if competitive pressures are strong, lower real prices for the products of the business. To the extent that real prices fall, customers are able to choose between using the increase in the purchasing power of their income to buy more of the business’s products or to buy more of other firms’ products.

The point is: improved productivity leads to increased real income; when that higher income is spent, jobs are created somewhere in the economy. This is why more than 200 years of investment in labour-saving equipment have not led to mass-unemployment. It’s also why, though non-economists speak of new technology ‘destroying’ jobs, economists prefer to say the jobs have been ‘displaced’ - moved from one industry to other industries.

If you look back at the history of our economy over the past century, you see technological advance making first agriculture and mining more capital-intensive, so that they are able to increase their output while accounting for an ever-falling share of the workforce, and since, the 1960s, a similar process occurring in manufacturing. All the employment growth has been in the services sector, with most of it in the more highly skilled occupations.

Productivity and immigration

The commitment of business people, politicians and even most economists to growth means almost all of them are believers in a high rate of population growth through high levels of immigration. It’s understandable for business people and politicians to believe in growth for growth’s sake - the bigger our economy the better. From a business perspective, the bigger the economy, the bigger their domestic market and so the easier it should be for them to increase their sales and profits.

But it’s not rational for economists to believe in growth for growth’s sake. They believe in faster economic growth only because it’s expected to lead to a higher material standard of living. But a higher standard of living requires higher income per person - that is, GDP has to grow faster than the population. If it doesn’t, nothing is gained. And if population were to grow faster than GDP, average living standards would fall.

Empirical research by the Productivity Commission and others over the years has concluded that immigration - even skilled immigration - does little or nothing to raise income per person. Why not? Because of the problem of productivity. An increased population requires increased provision of housing and public infrastructure: roads, public transport, schools, hospitals, police stations and all the rest. If this increased infrastructure investment fails to occur, the productivity of our infrastructure falls. This will be manifest in housing overcrowding, greater traffic congestion, longer hospital waiting times and so forth. Similarly, an increase in the workforce that’s not matched by an increase in the equipment workers are given to work with will lead to a decline in the average productivity of labour. In other words, and increase in the population requires a greater increase in capital investment - public and private - if it’s to lead to higher income per person.

This raises the old distinction between capital deepening and capital widening. Capital deepening involves the provision of greater capital equipment per worker - an increase in ‘capital intensity’ or the ratio of capital to labour - which will raise the productivity of labour. Capital widening involves increased investment to prevent an increase in the workforce causing a decline in capital equipment per worker - a decline in capital intensity - and a fall in the productivity of labour. Immigration does little to increase income per person because it requires a lot of investment just to stop average labour productivity falling.

Productivity and other advanced economies

It is well known to the economic managers, but not widely reported, that Australia is not alone in suffering slower productivity improvement since the turn of the century. Dr Philip Lowe, deputy governor of the Reserve Bank, observed in a speech in March 2014 that ‘productivity growth in many advanced economies has trended lower for some time now’. Labour productivity in the OECD economies averaged 1.9 pc over the 14 years to 2000, but 1.1 pc over the 13 years to 2013. Australia’s figures were virtually the same as this average, except that whereas the OECD average for the three years to 2013 fell further to 0.8 pc a year, Australia’s average recovered to 1.5 pc.

This common experience around the advanced economies suggests the underlying problem may be a worldwide slowdown in technological advance, but this is only conjecture.

Productivity and recessions

In my experience, the measures businesses take to lift their productivity - particularly by trying something new, reducing waste and abandoning unsuccessful projects and products - aren’t evenly distributed across the business cycle, but tend to come in a bunch, like busses. In the upswing of the cycle when profits are strong an optimism abounds, firms tend to expand, experimenting with new products and processes, and generally allowing staffing levels to creep up.

When the cycle turns and sales and profits slow down or fall, however, times get tougher and pessimism sets in. Firms seek to minimise the decline in profits by looking for ways to cut costs and reduce staff numbers. Unsuccessful processes, products and divisions, which should have been abandoned much earlier, are finally brought to an end. The least profitable firms in an industry may collapse or exit. Following Schumpeter, economists often refer to this as a process of “creative destruction”. What this means is that economic downturns often lead to surges in productivity.

When you remember that Australia hasn’t experienced a serious recession since the early 1990s, it make makes you wonder if a price of our good fortune isn’t a slow build-up of inefficient practices in the absence of a great reckoning that would have made our productivity figures look better. Along similar lines, however, it may well be that the pressure imposed on our tradables sector - particularly manufacturing and tourism - by the years of a high exchange rate has obliged those firms that have weathered the storm to become a lot more efficient than they were. The productivity debate has been led by people who imagine greater productivity to be a warm and cuddly thing. In reality, it’s often the product of adversity - firms forced to lift their game if they want to survive.

Productivity and microeconomic reform

It has become fashionable among economists to see a strong link between our productivity performance and microeconomic reform. Most economists attribute the surge in labour productivity and MFP in the second half of the 1990s to the effects of the Hawke-Keating government’s extensive micro reforms. But there’s no way they can prove this is the case. Examining productivity performance by industry doesn’t show much correlation with the major reform initiatives. And since the main reforms occurred in the second half of the 1980s, we’re being asked to believe the benefits of those reforms took about a decade to show up.

When the reform push was in full swing it was hoped the reforms would, by making the functioning of various industries more efficient and flexible, bring about a lasting increase in the rate of productivity improvement and economic growth. As we now know, however, the best the proponents of micro reform can claim is just a few years of above-average improvement, bringing about a once-only lift in the level of our productivity.

I find this a bit disillusioning. If micro reform to remove impediments to growth can’t lead to a lasting increase in the rate of growth, the benefits of micro reform are less than we initially imagined them to be. If the only way we can achieve even a temporary increase in economic growth is to come up with another dose of micro reforms, we’ll soon run out of reforms and willingness to pay the political and social price of reform. If repeated doses of reform are the only way we can maintain a reasonable rate of productivity improvement, there must be something badly amiss in our economy that no amount of reform is fixing.

My belief is that the peculiarities and limitations of the economists’ conventional model have warped their attitude towards productivity improvement. They know well that national productivity is a function of what goes on in each of the many firms that make up the economy, yet it is no part of the economists’ approach to study what happens within the individual firm or to imagine there is anything they or governments should say or do to affect what happens inside firms directly. Anything done may affect firm behaviour only indirectly via the monetary incentives firms face. Because the model assumes business always responds rationally to the incentives it faces, if there’s something lacking in the economy’s productivity performance the only available possibility is that something government is doing must be distorting the incentives facing private firms, causing them to operate less efficiently than they otherwise would. So governments should examine and reform their interventions in markets, reducing them in ways that encourage greater competition. So, problem with productivity = more micro reform.

But the model’s largely unnoticed effect on economists’ thinking about productivity doesn’t end there. Because the standard model’s unit of analysis is the individual - whether individual consumer or individual firm - it contains an inbuilt bias against collective action, including actions by governments. The model leads economists to the conclusion that, since the role of government is suspect, the desire for improvement in the economy’s functioning invariably leads in the direction of less government rather than more. Government intervention in particular markets may be reducing their efficiency, or the high tax rates needed to pay for a big public sector may be reducing incentives to work, save and invest.

By contrast, we know that with a knowledge economy, much productivity improvement should be coming from investment in human capital. The rise of the knowledge economy is prompting more of us to crowd into big cities where we can learn from face-to-face contact with each other. But this increases congestion and other infrastructure problems. So adequate - and effective - spending on infrastructure is an important part of maintaining productivity improvement.

This suggests there are two rival approaches to government efforts to improve productivity: measures that involve making government smaller, and measures that make it bigger. Guess which approach economists tend to focus on?

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