For true productivity gains, co-operate don't fight

When Peter Reith replaced Labor's Industrial Relations Act with the Workplace Relations Act in 1996, he changed the act's principal objective from the "prevention and settlement of industrial disputes" to "providing a framework for co-operative workplace relations". I'm not sure the Howard government always lived up to that ideal, but it was certainly the right idea.

John Howard was fond of saying we should emphasise the things that unite us, not the things that divide us. Again, I'm not sure he always lived up to that, but it was the right idea - particularly for relations between bosses and workers.

The principal objective of the Fair Work Act is to provide a "balanced framework for co-operative and productive workplace relations that promotes national economic prosperity and social inclusion". That's even better.

At a time when so many of our industries are under so much pressure to change from so many sources - the high dollar, the prudent consumer, the digital revolution, the deregulation of world airlines - we need all the co-operation we can get between employers and unions.

Most economists have rejected the claims of some that our seemingly poor productivity performance over the past decade can be blamed on the Fair Work Act that came into full effect only at the start of 2010.

But that's not the same as saying the act is without fault. And it's certainly not to deny the need for our industrial relations to be as conducive as possible to improved productivity.

If we were to believe all we see and hear, we'd conclude relations were pretty bad at present. I'm not convinced that's true. More likely, a handful of highly publicised, bitter disputes has provoked a lot of tough talking on both sides of the fence, and left us with the impression things are worse than they really are. Even so, too much of the debate about Fair Work has focused on whether it's got the balance right between the adversaries, and not enough on how much it's helping to turn adversaries into partners.

There are plenty of people who've always hated the unions, and plenty who've always hated the bosses. All of us can be lured into playing that game but, in all our interests, we need to resist the temptation. It's self-indulgent at a time when we need to pull together.

For industrial relations to become more co-operative, and hence more productive, we need give and take on both sides.

What managers need to accept is that workers are entitled to reasonable treatment. Managers want to do well out of their association with a business; so do workers. And, to adapt a quote, the economy was made for man, not man for the economy.

There are plenty of ways to improve the productivity of labour - and certainly, to cut the cost of labour - that involve making life more uncertain, insecure, unpleasant and even unhealthy for workers. If that's what "flexibility" means, it's hardly surprising workers resist it. Good managers resist the temptation to go down that shortcut to supposed prosperity.

Many proposals to "outsource" production or resort to contract labour aren't about two-way flexibility but about cutting costs by escaping existing in-house arrangements over pay and conditions. Good managers need to do better than that.

Australia's workers are relatively highly paid, with good conditions. This is a good thing, not a bad thing. It's certainly nothing to try to make workers feel guilty about. As any economist will tell you, our high pay rates are justified by our relatively highly educated and skilled workforce, by the high-quality capital equipment it works with, and by the sharing of this nation's considerable wealth.

The goal of management should not be finding ways to escape these high costs, but finding ways to defend our high wage rates with high productivity. In this endeavour they're entitled to full co-operation from their workers.

What workers need to accept is that the world economy is changing rapidly and as it changes we must change. Businesses must respond to the changing commercial pressures on them, or they will fail.

In a capitalist economy, businesses need to earn an adequate return on the shareholders' funds invested in them. In the final analysis, managers are paid to ensure their business remains profitable. They will do whatever it takes.

Such profits are not illegitimate, and they're not available to be plundered by workers demanding excessive wage rises or refusing to change in response to the changing pressures on the business.

Workers and their unions simply cannot pretend the pressures for change bearing down on the business are a problem for management, but not for them. The more they resist a creative response, the more managers will go around them in the search for cheaper labour.

Change - painful change - can't be avoided by attempting to strongarm management into including guarantees of job security in enterprise agreements. Guess what? There are no guarantees in an ever-changing market economy.

Much of the change being imposed on various industries will inevitably involve redundancies. The most workers can expect is decent redundancy pay, the avoidance of excesses designed to impress the sharemarket, and a preference for redundancies to be voluntary.

Professor Paul Gollan, of Macquarie University, argues the key to greater co-operation in the workplace is giving workers greater "voice" - formal arrangements within businesses by which employees are consulted, given their say and encouraged to propose improvements and "add value". Studies confirm such processes are associated with greater productivity.

Senior managers' "prerogative" - about which I say more in my little video on the website - is to ensure their staff is fully informed about the challenges facing the business.

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Fair Work debate fans the fighting mood

THE most disappointing thing about the review of the Fair Work Act and the reaction to it is the way they push industrial relations towards being more adversarial rather than less.

At time when so many businesses face unusually challenging pressures for structural change, we need more co-operation between the industrial partners, not more class struggle and barracking from the sidelines.

The standard approach to industrial relations reform is to see it as about "getting the balance right". There's a fundamental conflict of interest between labour and capital, we think, plus a wide difference in bargaining power, so the objective is to ensure the eternally battling parties are fairly evenly matched.

That's the public policy objective, of course. If you're on one side or the other, your objective is simply to get the rules changed in a way that gives you the drop over the other side.

The conventional view is that, with its attempt to install individual contracts as the chief form of bargaining and marginalise the unions, WorkChoices pushed the balance too far in the direction of employers.

So it was fair enough - particularly after voters seemed to reject WorkChoices so decisively - for Fair Work to push the balance back the other way. The review's job was to decide whether the balance had now been pushed too far the other way.

The trouble with the review is that it didn't do much more than adjudicate the rival claims, legal section by section. With two of the three members of the review being lawyers - and one a judge - you couldn't have expected anything else.

Although the media portrayed the employer groups' reaction to the review as angry, I suspect they were quite pleased. They won more points than they expected to, while the unions won fewer.

One trouble with the traditional approach to regulating industrial relations - supervise a fair fight - is that it's reinforced by all our other adversarial institutions. It comes naturally to lawyers, but also to politicians.

There's nothing Julia Gillard and Labor would love more than a rematch on industrial relations and there are plenty of urgers on the Liberal sidelines spoiling for a punch-up.

For once, however, Bruiser Abbott isn't tempted, judging correctly that such a them-and-us contest would greatly favour "them". Electorally, WorkChoices is still toxic.

Should Abbott win the election, it will be interesting to see what gap emerges between his pre-election rhetoric and his post-election policies. Many of his backers are hoping for a yawning chasm.

Just as the traditional industrial relations approach is adversarial, so the IR experts are highly factionalised. Most academic experts long ago chose sides between the unions and the employers. Trying to find experts who can see both sides of the argument is one of the trials of my job.

Wherever there are adversaries, there you can expect to find the media, doing their best to increase the fun by amplifying the conflict. What's new is to have the national dailies taking sides in their reporting, with the union side of the story virtually unmentioned.

Whenever there's a brawl, it's hard for interested bystanders to resist the temptation to join in. I suspect that's the story with big business leaders: they're not greatly affected, but they know whose side they're on.

Consider the results of last week's CEO Pulse survey of 96 chief executives. Fully 82 per cent of them think Fair Work is having a negative impact on productivity. That's for the whole economy. For their own industry, it's down to 60 per cent. And for their own business? Down to 51 per cent, with 45 per cent saying it's having no effect.

Coming from people with such obvious alignment, that tells me we don't have a lot to worry about. It reveals the classic survey gap between first-hand experience and the general impression people have picked up, mainly from the media.

My guess is a few big, militant unions are taking every advantage of Fair Work to make unreasonable demands. And they're being vigorously opposed by a few equally militant, unreasonable big businesses.

But we shouldn't allow people with a vested interest in conflict to misdirect us. The real problem with Fair Work is that it's not doing as much good as it could be at a time when bosses and workers need to pull together.

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We've come a long way on industrial relations

In all the argument about the rights and wrongs of Julia Gillard's Fair Work Act, it's easy to forget we've been making radical changes to our industrial relations and wage-fixing system since the late 1980s.

Since the labour market is such an integral part of the economy, it's reasonable to suppose those changes have made a significant contribution to the economy's markedly improved performance over the past two decades.

What you can't do is look at the macro-economic record and confidently attribute this improvement or that deterioration to either the Fair Work Act or the Work Choices regime that preceded it.

Why not? Because, particularly if you're talking about our weak productivity performance, the timing doesn't fit. Also because neither regime was or has been in force long enough to be sure they've had much effect on anything. Changes take time to make a mark.

But, above all, because when you take just one factor and use it to explain some particular development in the economy, you're unconsciously assuming ceteris paribus - all else remains equal. And in the real world, that's never true. For all you know, the development may be explained by some other factor, or combination of factors.

So whenever you see a protagonist in the debate confidently claiming the slowdown in productivity can be blamed on the industrial relations approach they oppose, know they're talking prejudice, not reasoned analysis.

As this week's review of the Fair Work Act reminds us, we've been overhauling our industrial relations and wage-fixing system for ages. For most of the time since Federation we operated under a uniquely antipodean system of federal and state "conciliation and arbitration".

In theory, all strikes were illegal because the system made them unnecessary. In practice, strikes were frequent, but short.

In theory, the commission running the system would provide conciliation to differing employers and unions, trying to help them reach an agreement. If this didn't work it would compulsorily arbitrate to impose a solution, usually roughly splitting the difference. In practice, disputes were almost always settled by arbitration. Unions would pull on a strike to get the umpire to intervene and impose a decision.

In theory, wage rises were controlled by the commission in a "national wage case", making them nationally uniform for all workers subject to particular "industrial awards", on which the system was built. In practice, you could get pay rises other ways, including by breaking out of the system if you had enough muscle. Some increases would "flow on" from one key award to all awards.

Get the feeling it wasn't working very well? The first attempt to restore order was to limit wage rises to those awarded by the national wage case, where wages were indexed to the consumer price index.

But indexation was abandoned in 1987 and wage rises were awarded in exchange for the removal of "restrictive work practices" (inefficiencies). Awards were restructured to reduce demarcations between people on different awards at the same workplace and to make awards more flexible.

In 1991, the commission introduced "enterprise bargaining" between unions and employers at the level of the individual workplace. It applied a "no-disadvantage [to employees] test" before ratifying agreements. In 1994, with a new Industrial Relations Act, a more formal system of collective bargaining at the enterprise level was introduced, the national wage case was ended and replaced with a system of small annual "safety net" award wage increases for workers unable to negotiate an increase.

All that happened under the Hawke-Keating government. From early 1997 the Howard government's Workplace Relations Act promoted the use of individual contracts (subject to the no-disadvantage test) by introducing "Australian workplace agreements", increased the emphasis on enterprise bargaining by reducing the content of awards to 20 "allowable matters" and reduced union power by outlawing compulsory unionism and making strikes legal ("protected") only during the negotiation of new agreements.

The Howard government's second major set of changes, Work Choices, took effect in 2006. It moved from a federal to a national system, sought to make individual contracts the main form of wage agreement by removing the no-disadvantage test, greatly increased the restrictions on unions where employers persisted with collective bargaining, and largely sidelined the commission.

After much criticism, in May 2007 John Howard significantly watered down these provisions by restoring a version of the no-disadvantage test and reinstating close scrutiny of individual contracts before approval.

Labor's Fair Work Act didn't really take effect until the start of 2010. It ended legislative recognition of individual contracts and restored collectively bargained enterprise agreements as the main form of wage-fixing. It largely restored the role of the commission under the cutesy title, Fair Work Australia. It reformed the award system, reducing more than 3000 federal and state awards to 122 simpler and less prescriptive "modern awards".

Some silly partisans have tried to blame Fair Work for our weak performance on the productivity of labour, but the figures don't bear this out. Productivity improved fastest under the Keating government's regime and the early years of the Workplace Relations Act, but then slowed and the weakness continued under both Work Choices and Fair Work. In any case, this ignores the huge effect of the special factors affecting productivity in mining and utilities.

But productivity isn't the only test of improved labour market performance. What about strikes? Working days lost per 1000 employees averaged 232 a year in the last days of arbitration, 176 under Labor's first Industrial Relations Act, 96 under its second act, 54 under Howard's Workplace Relations Act, 13 under Work Choices and 18 under Fair Work.

Some have blamed Fair Work for the small jump in days lost last year but most of this is explained by disputes involving the O'Farrell government and NSW public servants, who aren't covered by Fair Work.

Despite employer complaints, the minimum wage grew in real terms by less than 9 per cent over the 11 years to 2012. It dropped from 62 per cent of median full-time earnings in 1997 to 54 per cent in 2010.

The review of the Fair Work Act concludes that, since it came into force, "important outcomes such as wages growth, industrial disputation, the responsiveness of wages to supply and demand, the rate of employment growth and the flexibility of work patterns have been favourable to Australia's continuing prosperity, as indeed they have been since the transition away from arbitration two decades ago".

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No one knows how we'll pay for disability scheme

You may not have noticed, but last week was among the most significant of the Gillard government's term. The commitments made may do great good, but they will also cause much pain and gnashing of teeth in the years ahead.

Last week the nation made it crystal clear to its political leaders - federal and state - it wanted them to get on with implementing the national disability insurance scheme. After decades of turning a blind eye to the difficulties faced by the disabled and their carers, last week conscience struck.

Fine. You're a believer; so am I. But the scheme is very expensive: when fully implemented in 2018, an additional $8 billion a year. Or, as the politicians and the media usually prefer to put it, $32 billion over four years.

To give you an idea, $8 billion a year is more than will be raised each year by the carbon tax or more than twice what will be raised by the new mining tax.

So how will the disability scheme be paid for? No one has any idea. The pollies were arguing about that very question when - urged on by the same radio shock jocks who on other days rail against "debt and deficit" - the electorate put a rocket under them: Just do it!

That's why I have reservations. We behaved like a teenager with his first pay packet who goes out and buys a car on the never-never, without a moment's thought about how he'll fit the repayments into his budget.

Perhaps this was the only way an increasingly self-centred nation was ever going to commit to something so caring but expensive. Had we dwelt on how much it would cost and how we'd be paying for it, we might have made an excuse and passed on.

Even so, the accountant in me remains uneasy. Sometimes in politics, good deeds aren't born of the purest motives. The Productivity Commission report that recommended the scheme called for the pilot programs to begin in 2014.

I suspect Julia Gillard brought it forward a year because she wanted to be seen doing something worthwhile - and something that didn't have Kevin Rudd's fingerprints on it. She committed to spending just $1 billion over the four-year trial phase.

If Gillard has a clear idea of how she would afford the scheme when fully implemented, she's given no hint of it. All we know is that, contrary to the commission's advice, she expects the states to bear some of the cost.

I suspect she's fingered the states as a red herring, intending to draw attention away from her own lack of forethought. That's where we got to last week. She put the wood on the premiers to make a small contribution to the cost of their state's pilot scheme, but many declined. This could have been the usual story - whenever the feds require the premiers' co-operation, their hands go out: What's it worth to you?

If that was the premiers' motivation, I'm sympathetic. Though the states are responsible for provision of many costly public services - law and order, roads and transport, schools and hospitals - their taxing powers have been greatly constrained by the High Court, leaving them heavily dependent on the feds.

John Howard's decision to grant them the full proceeds from the goods and services tax was intended to solve their problem, but it's no longer the "growth tax" it was. Our consumer spending no longer outstrips our income the way it did, and an ever-growing proportion of our spending goes on items excluded from the tax, particularly private education and health.

So the premiers can't reasonably be expected to stump up for anything much. And, indeed, it's the feds who'll have to come up with a solution to their chronic revenue problem. This week a poll shows 84 per cent of respondents oppose increasing the rate of the GST to 12.5 per cent.

But only the Liberal premiers jacked up last week. The remaining Labor state and territory leaders played along. So maybe it wasn't the standard premiers' money-motivated bail-up.

There isn't a politician in the country with the courage to openly oppose the disability scheme. Gillard's lack of courage comes in telling us how she proposes to pay for it. Maybe she's decided she'll worry about that only if she wins the next election.

Tony Abbott's more likely to win it, of course. I suspect the hard-heads on his side had been intending to relegate implementation of the full scheme to the status of an "aspiration" to be afforded only when finances permit.

That now would be a lot harder to do, following the surge of public pressure that forced the premiers of NSW and Victoria to back down after just a day or so. Such forceful expressions of the public's will stay burnt on politicians' brains long after you and I have forgotten them.

Abbott's shadow treasurer, Joe Hockey, is saying it would be cruel to offer hope to the disabled when there was no guarantee the money could be found. In contrast, his more slick-tongued finance spokesman, Andrew Robb, says the full scheme would be introduced in 2018, but this "probably would require the removal or scaling back of other programs".

Don't forget Abbott would first have to cover the cost of abolishing the carbon tax and the mining tax. This is a man who professes to believe taxes must go down and may never go up. Now he's got to find a further $8 billion a year in spending cuts.

I find it hard to believe this would happen. But whatever happens, I foresee much pain and gnashing of teeth.

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TALK TO BIBLE MEANS BUSINESS

Sydney, Monday, July 30, 2012

Thanks for inviting me to be your discussion starter tonight. I’m not sure how much help I’ll be in your continuing exploration of the hypothesis that ‘there are identifiable values that contribute to the resilient prosperity of a culture’, but I’m happy to give you some observations to spark off - even if they convince you that I’m not on about what you’re on about.

On the question of business ethics, let me just say my strongest feeling on the subject is that businesses ought to be built on the principle of treating people well: producing a product you can be proud of, giving customers value for money, doing the right thing by suppliers and shareholders, and treating employees well. This means developing a high degree of mutual trust and loyalty between management and workers, putting effort into making employees’ work satisfying and fairly paid, giving them a degree of autonomy in their work and using these things - rather than KPIs and performance pay - to keep workers motivated, hard working and committed to the company’s objectives. I’m a great believer in emphasising intrinsic rather than extrinsic motivation: doing things well for their own sake, not for any external, monetary or status rewards good work may bring. I really believe it should be a high priority to make work more satisfying. I don’t believe in treating ‘em mean to keep ‘em keen. That’s not ethical - and it’s certainly not Christlike.

Much as most people hate change, this doesn’t mean aiming for a workplace that never changes in response to advances in technology, changing customer needs, competitive pressures (or a continued high exchange rate). Businesses must change, and sometimes - as now for many industries, including mine - change needs to be rapid and sweeping, with a lot of people losing their jobs. The ethical position is not to avoid change or even minimise it, but to bring it about in a considered and reasonable way, with never-ending explanation of why it’s necessary, consultation about the best response and considerate treatment of people who lose their jobs or have their jobs changed or moved. The ethical position is not to bluntly assert management’s right to manage without adequate explanation, and pull on a stand-up fight with the unions (or to ride roughshod over workers who are un-unionised). I believe there’s growing evidence that running businesses in this pro-people way leads to higher productivity and profitability. But even if there were no such evidence it would still be the right thing to do.

The other thing I wanted to say is to propose the notion of ‘balance’ as one of the values that contributes to resilient prosperity. A closely related value or virtue in my mind is ‘self-control’. One of the most useful ideas in economics is the notion of trade-offs and optimisation (rather than maximisation) leading to balance or equilibrium.

The world consists of many desirable, but conflicting, objectives. They’re in conflict mainly because of opportunity cost: we never have sufficient resources to satisfy all our desires, so we’re forced to choose. The world also consists of useful but rival means to achieve our objectives; again, we have to choose. It’s rarely the case that best outcome - the one yielding the most utility or satisfaction or prosperity - comes from choosing all of one and none of the others. The best outcome almost always arises from some combination of the conflicting objectives or the rival means to achieve objectives. This is what puts much of the challenge into life - including business life: finding the most desirable, optimising combination of conflicting objectives. We may profitably spend much of our lives seeking to improve the trade-offs we face. And the best trade-off may change over time as our preferences change and the environment in which we make our choices changes.

So the thing we’re seeking is the right balance. For many years my motto as a commentator has been Hard Head, Soft Heart. I want to think carefully and logically about how the world works and what I want out of life. But just as I don’t want to lead a life driven by instinct and emotion, so I don’t want to lead a life devoid of emotion. Emotion is very important; it’s emotion that makes us human. Take away emotion and we become calculating machines. We need emotion because it determines our preferences and goals - our ‘ends’ - but we need rationality, logic to determine the most efficient means to achieve our ends. So I think hard head, soft heart ought to be everyone’s motto. After all, who wants to be soft-headed or hard-hearted?

Such a motto helps us get the right balance in our lives. And one of the big risks and failings in life is lack of balance - going overboard in one direction or the other. Market economies - and the theory of market economies, conventional economics - tempt us to go overboard in the direction of self-interest, depersonalisation and materialism. Market economies are motivated by - powered by - self-interest, they encourage us to be terribly conscious of our needs and emotions, but to avoid thinking about the needs and emotions of the people we deal with, many of whom we don’t know. Market economies and conventional economics, with their focus on efficiency, tempt us to prioritise our material needs at the expense of our social, relational and spiritual needs. The material aspect of our lives is very important - no one could deny it - but there are other aspects of our lives that are also important. And, particularly for people in a country as affluent as ours, I find it hard to see how we can make increasing our material standard of living such a high priority - personally and as a government objective. That’s why I trust your definition of ‘prosperity’ is wider than just material prosperity. It needs to take account of the state of the natural environment (still material), but also the treatment of people: the fairness with which material prosperity is distributed, and the extent to which the pursuit of material comfort comes at the expense of people’s relationships and their spiritual life. For what does it profit a man if he gains the whole world and loses his own soul? True prosperity involves trade-offs, optimisation and balance.

I want to finish with an observation about a paradox at the heart of the market economy: for an individual to do well in that economy, he or she has to put a great amount of effort into resisting its blandishments. Its advertising and other marketing tempt us to eat too much, drink too much, spend too much and save too little, borrow more than we can handle, and sit round being entertained when we should be working, studying or exercising. Success in a market economy is reserved for those people who exercise all the virtues advertisers urge us to set aside: disciple, restraint and the ability to delay gratification - in short, self-control.

Don’t you think it’s strange that to succeed in a capitalist economy you have to be so good at not doing what the capitalists urge you to do? And that’s just material success. Making sure the temptations of modern life don’t damage your relationships with your spouse and your family - or with God - requires an even higher level of conscious effort.

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Smarter pricing would improve productivity

The debate over our seemingly weak productivity performance has come full circle, reverting to the explanation the big end of town was happy to accept under John Howard: almost all the weakness is explained by the special circumstances of the mining and utilities industries, which are nothing to worry about.

According to estimates by Reserve Bank researchers, after you exclude mining and utilities, labour productivity in the market sector improved at annual rates of 1.8 per cent over the 20 years to 1994, 3.1 per cent over the 10 years to 2004, and 1.7 per cent over the seven years to 2011.

However, Labour productivity in mining fell by 6.3 per cent a year over the past seven years because much higher prices justified the exploitation of harder-to-get-at deposits and because of spending on new mines that have yet to start producing.

Productivity in utilities (electricity, gas and water) fell by 5.5 per cent a year over the period, mainly because additional investment to improve the reliability of supply in the electricity and water industries has done little to increase output.

Note that a deterioration in our productivity performance isn't always a bad thing. Improved productivity is a means to an end, not an end in itself. The end is a higher material standard of living, and improved productivity is just one way for us to get richer. Another is for higher world prices to make uneconomic mineral deposits profitable to exploit. How could that be a bad thing, even if it does wreck our productivity figures?

And avoiding power blackouts and extreme water shortages is surely part and parcel of enjoying a high material living standard. If that requires us to invest in more power stations and higher-capacity power lines to cope with peak electricity demand - or requires us to build desalination plants to ensure we don't run out of water during severe droughts - what of it? Would it be better to go without to keep our figures looking good?

That's pretty obvious. But Dr Richard Tooth, of Sapere Research Group, and Professor Quentin Grafton, a water economist at the Australian National University, have separately advanced a more sophisticated argument: we could have avoided the expense of all that extra utilities investment had we been smarter in the way we set the prices of those commodities.

Starting with electricity, it has long been the case that we've needed to invest in sufficient generating and distribution capacity to cope with occasional peaks in demand that far exceed the average level of demand. These days, the peak comes on hot summer days. As household aircon has become cheaper and more ubiquitous, the peaks have shot ever higher than average demand, which is actually declining a little.

It costs a fortune to install the extra capacity - particularly the power-cable capacity - needed to ensure a lot of people turning on their aircon just a few days a year doesn't lead to the thing every state government dreads: blackouts.

But all this capital spending - and the political pain of 18 per cent increases in power bills - could have been avoided had state governments got on with installing smart meters in homes. This would have allowed prices that vary with the time of day. Significantly higher prices at the time of year when people are tempted to put on their airconditioner would prompt many to think twice. It would also be easy to encourage big industrial users to reduce their demand for relatively brief periods when household aircon was full blast.

The case of water is more complicated. Water bills are composed of a fixed charge plus a usage charge that varies with how much water you use. In (simple) theory, the usage charge should reflect the long-run marginal cost of an extra unit of water. The fixed charge is whatever additional amount is needed to cover the water company's full costs (including a reasonable return on capital).

However, the usage charge is usually too low to have much effect on consumption behaviour. And the simple theory doesn't apply well to commodities that have to be stored rather than produced to order, such as water.

As usual, in the last drought we relied on water restrictions, but they weren't sufficient to fix the problem (you can only police the water use that can be seen from the street, which means restrictions don't work well with business users) and we ended up building desal plants, only to mothball them when the drought broke.

The economists' study of the price elasticity of demand for water leads them to argue that, had user charges been raised high enough, supply could have been better conserved and desalination avoided.

User charges could have been increased to the point where they raised more revenue than was needed, thus allowing the fixed charge to be a subtraction from the total user charge. Dr Tooth argues such an arrangement would have been fairer in its treatment of low-income users.

If all those jumping on the productivity bandwagon were more genuine in their concern to raise efficiency, they would have a lot more to say about efficient pricing.

The most bizarre (and pathetic) political statement of last week was Wayne Swan's response to news the annual inflation rate had fallen to 1.2 per cent, the lowest in 13 years: "While the moderation in ... inflation is certainly welcome, many households continue to face cost of living pressures." And these guys wonder why they're not getting the appreciation they deserve.

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OK gloomsters, let's run some worst-case scenarios

In the long boom before the global financial crisis, when economists convinced themselves they'd achieved the Great Moderation and everyone was confident the good times would roll on forever, anyone who thought they saw a problem looming was either ignored or dismissed as a fool.

In the North Atlantic economies' continuing agonies since the crisis, it's been roughly the reverse. Excessive optimism has swung to excessive pessimism and anyone who thinks they see a problem looming gets a microphone and loud speaker stuck in front of their face.

Now it's the people who don't think the end is nigh who tend to be ignored. Our cyclical switch to pessimism is being compounded by the media's natural bias in favour of bad news and the tendency of people who dislike the Gillard government to believe everything in the economy has gone to hell.

One person who thinks things aren't as bad as they're being painted is Glenn Stevens, governor of the Reserve Bank. He gave a speech this week in which he begged to differ with the doomsayers. The cogent arguments he advanced deserve more attention than they've been given.

When it comes to dark forebodings, first prize goes to fears of a break-up of the euro. But worries about a hard landing in China are now coming second. Stevens examines the figures and concludes they show "Chinese growth in industrial output of something like 10 per cent, and gross domestic product growth in the 7 to 8 per cent range. To be sure, that is a significant moderation from the growth in GDP of 10 per cent or more that we have often seen in China in the past five to seven years."

But not even China can grow that fast indefinitely and there were clearly problems building up. It's far better the moderation occurs, he argues, if this increases the sustainability of future expansion.

What's more, the Chinese authorities have been taking well-calibrated steps in the direction of easing macro-economic policies, as their objectives for lower inflation look like being achieved and as the likelihood of slower global growth affecting China has increased.

Next he responds to the pessimists' greatest fear of disaster in the domestic economy: a collapse in house prices. He's not convinced they're overvalued by our historical standards. And while, expressed as multiples of annual household disposable income, they seem very high compared with American prices, they are within the pack of other developed countries. It's the US that seems out of line.

But Stevens emphasises he's not saying there's no possibility house prices will fall. "It is a very dangerous idea to think that dwelling prices cannot fall," he says. "They can, and they have." But the ingredients you'd look for as signalling an imminent crash seem even less in evidence now than five years ago.

"Even though we don't face immediate problems, we should ask: what if something went wrong?"

OK, so let's look at some worst-case scenarios. If the thing that goes wrong is a "major financial event" emanating from Europe, he says, the most damaging potential transmission channel would be if there were a complete retreat from risk, capital market closure and funding shortfalls for financial institutions.

This would be a problem for many countries, of course, not just us. But in that event the Aussie dollar might decline, perhaps significantly.

"We might find that, in an extreme case, the Reserve Bank - along with other central banks - would need to step in with domestic currency liquidity, in lieu of market funding. The vulnerability to this possibility is less than it was four years ago; our capacity to respond is undiminished and, if not actually unlimited, is not subject to any limit that seems likely to bind."

An alternative version of this scenario, if it involved the sort of euro break-up about which some people speculate, could be a flow of funds into Australian assets. In that case our problem might be not being able to absorb that capital. But that means the banks would be unlikely to have serious funding problems.

If the thing that went wrong was a serious slump in China's economy, the Aussie would probably fall, Stevens says, which would provide expansionary impetus to the Australian economy. But more importantly, we could expect the Chinese authorities to respond with stimulatory measures.

"Even if one is concerned about the extent of problems that may lurk beneath the surface in China - say in the financial sector - it is not clear why we should assume that the capacity of the Chinese authorities to respond to them is seriously impaired.

"And in the final analysis, a serious deterioration in international economic conditions would still see Australia with scope to use macroeconomic policy, if needed, as long as inflation did not become a concern, which would be unlikely in the scenario in question."

Next, what if house prices did slump after all? In such a scenario people typically worry about two consequences. The first is a long period of very weak construction activity, usually because an excess of housing stock resulting from previous over-construction needs to be worked off. But we've already had a long period of weak residential construction and it's hard to believe it could get much weaker at the national level.

The second common worry is about what a slump in house prices would do to the balance sheets of the banks and other lenders. But this scenario is regularly covered by the Australian Prudential Regulation Authority in its "stress-testing" of the banks.

"The results of such exercises always show that even with substantial falls in dwelling prices, much higher unemployment and associated higher levels of defaults, key financial institutions remain well and truly solvent."

Stevens points out that a lot of the adjustments we're complaining about at present - including households' higher and more normal rates of saving, a more sober attitude towards debt, the reorientation of the banks' funding away from short-term foreign borrowing, and weak house prices - are strengthening our resilience to possible future shocks.

"The years ahead will no doubt challenge us in various ways, including in ways we cannot predict. But what's new about that? Even if the pessimists turn out to be right on one or more counts, it doesn't follow that we would be unable to cope.

"Acting sensibly, with a long-term focus, has as good a chance as ever of seeing us through," Stevens concludes.

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Industry captures regulation of taxis

Does changing the government make much difference? Both sides of politics always assure us it will. But judging by the infrequency with which we do it, we seem doubtful.

At the state level the national swing from Labor to the Coalition is almost complete, providing a good opportunity to test the question. And a good test is the regulation of industry.

Despite both sides' protestations of undying concern for the welfare of ordinary voters, it gets harder to avoid the suspicion that governments regulate industries for the benefit of the businesses rather than their customers.

Take the case of taxis. We've been dissatisfied with the service provided by taxis for many a moon. They're expensive, but often don't offer good service: they're too hard to find at certain times, they don't turn up or take far too long to arrive; too many drivers don't know where to go, or are unfriendly.

But the outgoing Labor governments did far too little to improve the position. It got so bad in Victoria the Baillieu government promised action and appointed Allan Fels, the former chairman of the Australian Competition and Consumer Commission, to conduct an inquiry.

The taxi industry is highly regulated by state governments. What's the goal of this regulation? It's supposed to be to ensure we're provided with a safe and reliable taxi service at a reasonable price. In practice, the goal has evolved into the protection of a highly lucrative financial investment, the taxi licence plate.

Since about the time of the Depression, governments have sought to control the number of taxis by issuing a limited quantity of licence plates. Initially, and for many years, these licences were issued free to people wanting to drive taxis.

Because the supply of licences was limited relative to the demand for them, licence plates became valuable in their own right. They exist in perpetuity, and people who'd been given one by the government were able to sell it to someone else.

That someone may be a person who wants to drive a taxi, but doesn't have to be. And ownership of taxi plates doesn't imply ownership of the car to which those licence plates are screwed. You can "assign" (rent) the plates to a taxi operator for a fee, who buys the car and puts it on the road. Operators may drive the car themselves, or they may get others to do the driving.

Thus did the taxi licence plate transform into a valuable financial investment, with an active market in their purchase and sale. According to Professor Fels's interim report, the value of plates has been rising for years and Melbourne plates now change hands for up to $490,000 a pop.

Licences are assigned to operators for a fee of about $35,000 a year, thus yielding a direct return to their owners of about 7 per cent. Allow for capital gain and the overall return rises to about 16 per cent a year.

Not a bad investment. Now get this: according to the Fels report, in 1985 only about 4 per cent of Victorian taxi licences had been assigned to others. By 1998, about 45 per cent of metropolitan licences had been assigned. And by December last year it was up to about 70 per cent.

Because assignment fees are so high, not enough income is left for taxi operators and even less for drivers. Taxi fares are controlled by the government and the need to pay drivers more - they get an average of about $13 an hour, according to Fels - is often used to justify fare increases.

But every time fares increase so do the assignment fees charged by the licence owners, justifying a further rise in value of licences.

Fundamentally, however, what causes the rising value of licences is their growing scarcity relative to demand. Who is it that limits the number of licences on issue? The government. Who does this benefit? The owners of licence plates. The industry is being regulated largely for the benefit of absentee landlords, so to speak.

Taxi drivers get a terrible deal. They generally get 50 per cent of their take, but they're not employees and have to bear many costs themselves. They get no workers compensation cover, no holidays or superannuation and have to pay the goods and services tax.

Is it any wonder the quality of drivers is often poor, turnover is high and it's hard to get recruits? And yet most of our complaints about taxis relate to the performance of drivers.

Fels's key proposal in Victoria is for the government to issue new taxi licences to any qualified person for a fee of $20,000 a year. New licences would not be transferable and issued only to owner-drivers.

This would make it easier for drivers to become owners. It would force the existing licence plate owners' assignment fee down to $20,000 a year, still leaving them a reasonable return, but lowering the capital value of their plates to about $250,000.

Taxi operators would benefit from the lower assignment fees and this would allow the drivers' share of their take to be raised to 60 per cent. This, in turn, would justify making greater demands on drivers, including requiring them to pass a more stringent street and location knowledge test.

Now you see why licence-plate owners are opposing these reforms so vigorously. We'll see if Ted Baillieu stands up to them with any more fortitude than his Labor predecessors.

The specifics of taxi regulation in NSW differ somewhat from those in Victoria but the general principles are much the same - as are the complaints from taxi users. Will Barry O'Farrell try harder than Labor to fix things? So far he hasn't even called for a report.

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Reserve turns spotlight on dark side of innovation

There are few words in the business bible more holy than "innovation". And I'm a believer in its great virtue. But, like many things in economics, sometimes what's usually a good thing can be a bad thing - even a terrible thing.

In a speech on banking, the deputy governor of the Reserve Bank, Dr Philip Lowe, drew attention to the dark side of innovation in the financial sector and advocated closer regulation of it. Here's what he said, with my interpolations.

"Over many decades, our societies have benefited greatly from innovation in the financial system. Financial innovation has delivered lower cost and more flexible loans and better deposit products."

It has provided new and more efficient ways of managing risk, he says, helped our economies to grow and our living standards to rise.

"But financial innovation can also have a dark side," he says. "This is particularly so where it is driven by distorted remuneration structures within financial institutions, or by regulatory, tax or accounting considerations."

Ain't that the truth. Distorted remuneration structures go a long way to explain the origins of the global financial crisis. People paid commissions to give home loans to people who couldn't possibly pay them off. People on Wall Street hugely rewarded when their bets pay off, but suffering no great personal loss when their bets blow up.

People who invent toxic products and flog them to their own clients. Credit rating agencies paid handsomely to give toxic products triple-A ratings.

Because (for reasons I'm yet to fully understand - or meet anyone who does) remuneration in the financial sector is so eye-wateringly gargantuan - enough to make chief executives envious - it attracts many of our brightest minds, who could be advancing the frontiers of science or managing the economy, but instead spend their days finding ways around financial regulations, tax law and accounting conventions.

I suppose you'd have to be hugely rewarded to devote your life to making such an antisocial contribution.

Lowe says problems can also arise where the new products are not well understood by those who develop and sell them, or by those who buy and trade them.

"Over recent times, much of the innovation that we have seen has been driven by advances in finance theory and computing power, which have allowed institutions to slice up risk into smaller and smaller pieces and allow each of those pieces to be separately priced," he says.

"One supposed benefit of this was that financial products could be engineered to closely match the risk appetite of each investor. But much of the financial engineering was very complicated and its net benefit to society is debatable."

Many of the products were not well understood, he says, and many of the underlying assumptions used in pricing turned out to be wrong. Even sophisticated financial institutions with all their resources [all those highly paid, super-bright people] didn't understand the risks at a micro-economic nor a system-wide level.

"As a result, they took more risk than they realised and created vulnerabilities for the entire global financial system."

Just so. We live in an era when it's the height of fashion to see much of the management task as managing the many and varied "risks" to which businesses are subject. It's a useful way of thinking.

One way to manage risk is to spread it very thinly between a large number of people. All insurance policies are longstanding examples of this approach. Another approach is to join together people facing opposite risks. For instance, a contract between someone who stands to lose if the dollar falls and someone who stands to lose if it rises.

The market has developed lots of "plain vanilla" derivatives that allow firms to swap their interest-rate or foreign-exchange risks in this way. This is socially beneficial innovation.

But when derivative contracts become far more complicated than that, there can be problems. Risk management can itself be risky. It's hard to escape the risk of human fallibility in all its forms: the risk that people (even professionals, let alone punters) don't really understand the risks they're taking on; the risk of people's judgment being clouded by greed or hubris (nothing's gone wrong so far and that's because I'm so smart).

Then there are all the previously non-existent risks you create when you invent assets for which there's no market price, but for which you calculate a price using a fancy mathematical formula. All such synthetic prices are built on a host of explicit and hidden assumptions.

Forget that small fact and you can come horribly unstuck, as we've already discovered in the global financial crisis to our huge and far-from-over cost - as witness, Europe.

The question is, how can society obtain the benefits that financial innovation delivers while reducing the risks it entails? Lowe concedes this won't be easy, but sees a way forward in greater public sector oversight of areas where innovation is occurring.

"I suspect that the answer is not more rules, for it is difficult to write rules for new products, especially if we do not know what those new products will be, and the rules themselves can breed distortions," he says.

But one concrete approach is for supervisors [such as our Australian Prudential Regulation Authority] and central banks to pay very close attention to areas where innovation is occurring: to make sure they understand what's going on and to test and probe institutions about their management of risks in new areas and new products.

"Ultimately, supervisors need to be prepared to take action to limit certain types of activities, or to slow their growth, if the risks are not well understood or not well managed," he concludes.

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Productivity story not what we've been told

At last instead of jumping to conclusions and riding hobby horses we're making good progress in analysing the causes and cures of the slowdown in our economy's productivity improvement. There's more to it than you may think.

Following the analysis by Saul Eslake for the Grattan Institute we've had a contribution from the Productivity Commission's great productivity expert, Dean Parham, and a synthesis of the state of our knowledge by Patrick D'Arcy and Linus Gustafsson in the latest Reserve Bank Bulletin. Let me tell you what they find.

Productivity refers to the efficiency with which an economy employs resources (inputs) to produce economic output (goods and services). It matters because improvement in productivity is the key driver of growth in income per person - and hence, our material standard of living - in the long run.

The trend in productivity improvement is determined by the development of new technologies and by how efficiently resources - the "factors" of production: land, labour and capital - are organised in the production process.

The commonest and easiest way to measure productivity is to measure the productivity of labour. You take the total quantity of goods and services produced in a period and divide it by the total number hours of labour used to produce it, thus giving output per unit of labour input.

Figures for the market economy show labour productivity improved at the annual rate of 1.8 per cent over the 20 years to 1994, then by 3.1 per cent over the 10 years to 2004, then by 1.4 per cent over the seven years to 2011.

You see there how productivity surged during the second half of the 1990s, but has since slowed to a rate of improvement ever lower than during the lacklustre '70s and '80s. That's what the fuss is about.

The main way we improve the productivity of workers is to give them more machines to work with. Economists call this "capital deepening". Another way to think of it is that we've increased the ratio of (physical) capital to labour.

The part of the improvement in labour productivity that can't be explained by capital deepening is referred to as "multi-factor productivity" - the quantity of output produced from a given quantity of both labour and capital.

It turns out that capital deepening accounts for 1.3 percentage points of the annual improvement in labour productivity during both the 20 years to 1994 and the 10 years to 2004, and then an amazing 1.8 percentage points over the seven years to 2011.

The first conclusion from this is that the slowdown in labour productivity can't be explained by any decline in business investment in more machines. It's thus fully explained by a deterioration in multi-factor productivity.

Multi-factor productivity improved at an annual rate of 0.6 per cent over the 20 years to 1994, by 1.8 per cent over the 10 years to 2004 and by - get this - minus 0.4 per cent over the seven years to 2011.

Fortunately, the position isn't as bad as that looks. The decline in multi-factor productivity is more than fully explained by the special circumstances of just two industries: mining and "utilities" (electricity, gas and water).

Mining has seen huge investment in new production capacity that has yet to come on line. And the sky-high prices for coal and iron ore have justified the exploitation of more inaccessible deposits. Utilities have seen much investment in electricity and water infrastructure to improve the reliability of supply.

When you exclude mining and utilities you find, first, that over the past seven years capital deepening has proceeded at the same 1.3 per cent annual rate as experienced in the previous 30 years. Second, although the annual rate of multi-factor productivity improvement has slowed from 1.9 per cent over the 10 years to 2004 to plus 0.4 per cent over the latest period, that's only a bit slower than the 0.6 per cent we experienced during the 20 years to 1994.

In other words, the main thing we have to explain is not an abysmal performance at present (after you allow for the special factors in mining and utilities) but why the unprecedented rate of improvement in multi-factor productivity during the 1990s wasn't sustained.

The authors' calculations confirm the recent slowdown in multi-factor productivity has occurred across virtually all market industries. So it's a general phenomenon.

The explanation favoured by many economists is that the surge in productivity was caused by all the microeconomic reform in the 1980s and early '90s. The subsequent fall-off, they say, is caused by the absence of further reform.

But the authors' examine other, alternative or complementary explanations. They note that "at a fundamental level, productivity is determined by the available technology (including the knowledge of production processes held by firms and individuals) and the way production is organised within firms and industries".

So a possible explanation for the surge and subsequent decline in multi-factor productivity improvement, they say, is the pattern of adoption of information and communications technologies.

Then there's the contribution to productivity from improved "human capital" - the education, training and skills of the workforce. One indicator of education and experience is the Bureau of Statistics measure of "quality-adjusted hours worked".

This has been growing at a consistently faster pace than the standard measure of hours worked since the 1980s, indicating that education and experience are likely to have made positive contributions to multi-factor productivity over this period.

However, the pace of growth of this measure has slowed, suggesting a smaller contribution from improving labour quality has played some role in the productivity slowdown.

Another, possibly contributory explanation for the slowdown in productivity improvement is that, over the course of the long economic expansion between the early '90s recession and the mild recession of 2008-09, the incentives for firms, workers and governments to implement productivity-enhancing changes gradually weakened. So broad-based economic prosperity has probably eased the pressures driving productivity improvements.

Most productivity-enhancing changes involve a degree of reorganisation than can be difficult for firms and workers. So without clear incentives for change there is unlikely to be a strong focus on enhancing productivity.

My conclusion from this thorough analysis of the problem is that we don't have a lot to worry about. That's because, first, when you dig into the figures you discover they're not nearly as bad as they look.

Second, the structural change now hitting so many of our industries is just the thing to (painfully) oblige them to lift their productivity.

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