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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Banks facing structural change, too

As I'm sure you've gathered, a surprising number of our industries are going through a painful, job-shifting process economists euphemistically refer to as "structural adjustment". You've heard at length about the tribulations of mining, manufacturing, tourism, retailing, aviation, bookselling, newspapers and free-to-air television.

Then there's all the angst and words spilt by the media, politicians and people with mortgages over structural change in banking. Huh?

When people have been carrying on about how the banks have stopped moving mortgage interest rates in line with changes in the Reserve Bank's official interest rate, they've actually been complaining about just one consequence of the structural change that's being imposed on banks around the world in reaction to the devastation wrought by the (continuing) global financial crisis.

Just how the banks are being forced to change was explained by the deputy governor of the Reserve Bank, Dr Philip Lowe, in a speech last week (on which I'll be drawing heavily).

All of us can remember the halcyon days before the financial crisis when mortgage interest rates moved in lock step with the official rate. Unfortunately, they were only halcyon on the surface. Underneath, big trouble was brewing.

Particularly in the United States and Europe, there was a lot of cheap money flowing around, so the banks got quite slapdash about whom they lent to. They lent at interest rates that were artificially low, failing to reflect the riskiness of the project and the chance they wouldn't get their money back.

They also greatly increased their "gearing" - the ratio of borrowed money to shareholders' capital they used to finance their activities. When business is booming, becoming more highly geared accelerates the rate at which your profits grow. When business turns down, however, it hastens the rate at which profits shrink and turn to losses.

As we know, the day of reckoning did come, many banks in the US and Europe got into deep trouble and had to be bailed out by their governments to prevent them collapsing and causing a depression. Even so, the North Atlantic economies dropped into deep recession, from which they've yet to properly emerge.

In the meantime, the bank regulators and the global financial markets are forcing the world's banks to change their ways and lift their game - in short, to operate more safely, reducing the risk of getting into difficulties. Although our banks are well regulated and didn't get into bother, they're still affected by this tightening up.

Banks are now required to hold a higher proportion of their funds in shareholders' capital and a higher proportion of their assets in liquid form, making it easier for them to cope with a surge in depositors wanting to withdraw their money.

The financial crisis made Australians realise how dependent our banks had become on using short-term overseas borrowings to meet the needs of local home and business borrowers. Before the crisis the interest rates our banks paid on these foreign borrowings were unrealistically low; now they're much higher, to adequately reflect the risks involved.

Our authorities, and our sharemarket, have been pressing the banks to do their overseas borrowing over longer periods and raise a higher proportion of their funds from local depositors.

Do these efforts to make our banks safer and more crisis-proof sound like a good thing? They are. But, like everything in the economy, they come at a price.

What banks do is act as intermediaries between savers on the one hand and borrowers on the other. The costs they incur in performing this invaluable service (including the return on the shareholders' money invested in their business) are called the "cost of intermediation", which is the gap between the average interest rate they charge on the money they lend out and the average interest rate they pay to depositors and other lenders.

The cost of making our banks safer - by requiring them to hold higher proportions of share capital and liquid assets - has raised the cost of intermediation. Most of this higher cost has been passed on to the banks' mortgage and business borrowers.

The higher cost of borrowing abroad and borrowing from local depositors has also been passed on.

This explains why, since the early days of the financial crisis, the banks have been raising mortgage rates by more (or cutting them by less) than movements in the official interest rate. Over the 10 years to 2007, the variable mortgage rate averaged 1.5 percentage points above the official rate. Today, it's about 2.7 percentage points above.

That's what all the complaints have been about. Now you know why it's happened. But this bad news has been accompanied by three bits of good news which have had far less attention.

First, much of the increase in mortgage rates is explained by the very much higher rates being paid to depositors as the banks compete furiously for our money. Before the financial crisis, deposit rates were well below the official rate; now they're above it (particularly on internet accounts). Depositors outnumber people with mortgages by two to one.

Second, safer banks mean people who invest in bank shares (which is everyone with superannuation) are running lower risks - meaning their profits don't need to be as high. The boss of Westpac, Gail Kelly, said recently its return on shareholders' equity had fallen from 23 per cent before the crisis to 15 per cent.

Finally, to reduce the pressure on bank borrowers caused by the banks' now higher margin above the official rate, the Reserve Bank has cut it by about 1.5 percentage points below what it would otherwise be.

Structural adjustment is always painful - but there's always someone who's left better off.

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How our political prejudices affect confidence

I've realised we won't be satisfied with the state of the economy until the Liberals get back to power in Canberra. That's not because Labor's so bad, or because the Libs would be so much better, but because so many people have lost confidence in Labor as an economic manager.

The conundrum is why so many people could be so dissatisfied when almost all the objective indicators show us travelling well: the economy growing at about its trend rate, low unemployment, low inflation, rising real wages, low government debt - even a low current account deficit.

And yet the media are full of endless gloom, not to mention endless criticism of the Gillard government. Last week the NAB indicator of business confidence dropped to a 10-month low. And while the Westpac-Melbourne Institute index of consumer confidence recovered almost to par, that's a lot weaker than it ought to be.

Admittedly, the good macro-economic indicators do conceal a much greater than usual degree of structural adjustment going on. But these adjustments - which are generally good news for consumers - seem to be adding to the discontent rather than the root cause of it.

The Gillard government has been far from perfect in its economic policy, but you have to be pretty one-eyed to judge its performance as bad. Similarly, only the one-eyed could believe an Abbott government would have much better policies. It's likely to be less populist in government than it is opposition but, even so, Tony Abbott is no economic reformer.

Gillard's problem is not bad policies, it's Labor's chronic inability look and act like our leader and command the public's respect and comprehension. This is a government that doesn't believe in much beyond clinging to office, and the punters can smell its lack of principle.

To be fair, on the question of economic competence Labor always starts way behind the ball in the public's mind. Decades of polling reveals the electorate's deeply ingrained view the Libs are good at running the economy and Labor is bad.

This is what feeds both the Libs' born-to-rule complex - their utter assurance that all Labor governments lack legitimacy - and Labor's barely concealed inferiority complex.

The Hawke-Keating government did manage to turn the electorate's conventional wisdom on economic competence around for most of its 11-year term.

Labor in its present incarnation has never been able to pull this off. It's lost its race memory of how to govern. All this is compounded by the manner of Gillard's ascension, her non-maleness, her inability to make the punters warm to her and the uncertainties (and broken promises) of minority government. But the problem was apparent before Labor decided it could stomach Kevin Rudd no longer.

It's true the media environment is more unhelpful than it was in Hawke and Keating's day. Increased competition has made the media more relentlessly negative - more uninterested in anything but bad news - which must eventually have some effect on the public's state of mind.

In their search for a new audience in response to the challenge of the digital revolution, part of the media has become more partisan and more unashamedly hostile to all things Labor.

You see this in the radio shock jocks, but also in the national dailies, which have adopted the Fox News business model of telling a section of the potential audience what it wants to hear, not what it needs to know.

It seems a universal truth of the commercial media that the right-leaning audience is both more numerous and better lined than the left-leaning.

So, for instance, a favourite commercial tactic at present is to search for, and give false prominence to, all stories that portray our almost-dead union movement as a threatening monster about to engulf big business.

Boosting productivity equals making industrial relations law more anti-union. End of story. When Treasury people give speeches that fail to echo this infallible truth it's a clear sign they've been "politicised" and we need to find a few hyper-ideological economics professors to misrepresent what they said.

When Hawke and Keating were in power, business leaders judged it wise to keep their natural political sympathies to themselves and work with the elected government.

But with Gillard so far behind in the polls, so ineffective in maintaining relations with big business, with the general media so anxious to accentuate the negative and a significant part of the serious press telling them how badly they're being treated and holding out a microphone, it's not surprising big business people have become so unusually vocal in their criticism of Labor.

When God's in his heaven and the Libs rule in Canberra, business people jump on anyone they consider to be "talking the economy down". But so great is their loathing of the Gillard government that business is leading the chorus of negativity. How they see this as in their commercial interest I'm blowed if I know.

While John Howard was in power, the index of consumer sentiment showed respondents who intended voting for the Coalition to be significantly more confident about the economy than those intending to vote Labor. At the time of the 2007 election, however, the two lines crossed and Labor voters became significantly more confident than Coalition voters.

The latest figures show the overall confidence index at 99, while the Labor voters' index is up at 124 but the Coalition voters' index down at 79. Since Coalition voters far outnumber Labor voters, it's clear a change of government would do wonders for measured consumer confidence.

The same would probably be true for measured business confidence. Suddenly, business would be back talking the economy up, and the partisan media would revert to backing up our leaders rather than tearing them down.

But how much difference that would make to the objective economic indicators is another question.

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National productivity comes from firms' productivity

We've been debating what needs to be done to lift Australia's flagging productivity performance for a year, but only this week have we stopped using it in the unending political blame game and got down to some solid economic analysis.


The breakthrough came in a much-discussed speech Dr David Gruen, of Treasury, delivered to the annual Australian Conference of Economists in Melbourne.

Gruen made the apparently hugely controversial point that the primary responsibility for the productivity of the private sector - its output per unit of input - rests with the firms making up that sector and only secondarily with the government.

The government's role is in supporting the productive capability of the economy through investment in education and training, science and research, and infrastructure.

"Government involvement in these sectors is important," Gruen says. "Markets left to their own devices will tend to result in too little investment where there are social or spill-over benefits [in the jargon, 'positive externalities'] to the broader community beyond the returns available to a private investor.

"Governments influence the environment in which firms engage with each other and make investment and production decisions. They set the rules of the game, if you like, and affect the incentives that firms face, and their flexibility to respond."

But it's businesses that do the playing. So what do we know about the drivers of productivity improvement in the private sector? Well, a fair bit of empirical research has been done locally and overseas in recent years.

It shows that overall productivity improves in two different ways. One source is greater technical efficiency through innovation within the firm. Technical improvement comes about through research and development within the firm, or in partnership with the formal research sector.

But as a small country, most of the technology put into production in Australia is first developed overseas, Gruen says. A survey by the bureau of statistics shows only a small fraction of our innovative firms do things that are genuinely new to the world, or even new to Australia. Much more innovation is simply new to a particular industry.

"What usually distinguishes leading organisations is not so much their ability to create knowledge, but rather their ability to absorb technology developed elsewhere and apply it to their own circumstances," he says.

Why do firms innovate? According to the bureau's survey, three-quarters of innovative firms report undertaking innovation to improve profits. About 40 per cent also wanted to increase or maintain their market share and a quarter needed to develop products that were more competitively priced.

That's pretty much what you'd expect, but the second source of productivity gain is less obvious and less benign: it improves when production in an industry shifts from low-productivity firms to high-productivity firms.

A study of Australia firms in the 1990s found a remarkably wide range in their efficiency. The labour productivity of the most efficient firms was about four times that of the least efficient. Only about half this difference seems to be explained by differences in size.

So the productivity of an industry is improved when low-productivity firms are taken over or otherwise cease to exist, and also when new businesses with bright ideas start and grow.

Few people realise how much turnover there is of firms, even when the economy is growing strongly. According to figures from the bureau, about 8 per cent of firms close down each year. And about 40 per cent of new firms exit in less than four years.

Get this: overseas estimates suggest the net effect of the entry and exit of firms accounts for between a fifth and a half of the improvement in labour productivity over time. In high-technology industries, in particular, start-ups play an important role in promoting technological adoption and experimentation, Gruen says.

Hint to politicians: "Policies that act to slow the movement of resources will tend to limit this source of productivity improvement."

Another way to study productivity at the firm level is to look at management practices. Like productivity, management is about how well resources are used in production. So if you can rate particular management practices and give management teams a score, maybe this will help explain productivity differences across firms and even across countries.

One long-running study is doing this for 9000 medium and large manufacturing firms in 20 countries. It gives good ratings to firms that monitor what's going on in the firm and use this information for continuous improvement; set targets and track outcomes, and promote employees based on their performance.

The study shows management practices in Australia are mid-range: well below the United States, Germany, Sweden, Japan and Canada, but similar to France, Italy and Britain. And we have a larger tail of companies at the poor management end of the distribution compared with the US.

Looking at the performance of Australian firms, large manufacturers tend to be much better managed than small ones - a worry because our firms tend to be smaller than those in other countries. And it does seem clear better-managed firms are more innovative and have higher productivity.

Gruen argues periods of significant structural change - as at present - are often periods of growth and reform for the economy.

For a firm that's been doing the same thing for a long time, changes in business models are risky, difficult and may well require staff lay-offs. But when structural change means doing the same old thing is likely to be unprofitable, the opportunity cost of transforming work practices is substantially lowered. Structural change usually involves firms coming under greater competitive pressure. And tough competition and innovative activity seem to go together.

In Australia, firms that report having more competitors, that are in industries with low mark-ups, that export, or that experience downward pressure on profit margins are more likely to be innovators.

Case studies of Australian manufacturers hit by the reduction of import protection in the 1980s and '90s show the firms that succeeded did so by changing their practices. The number of plants diminished, plants became more specialised, model ranges were cut and world-best technology introduced.

Of course, some firms close down and leave the industry. But that's the harsh part of the lovely sounding productivity improvement: Competition boosts productivity partly by moving resources to more successful firms.

Get it? When politicians protect firms from closing, they risk stifling productivity improvement. For countries, comfortable and rich don't go together.

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Why retailers aren't so greedy

When you buy something in a supermarket or a department store, how much of the price you pay is the store's mark-up? And of that mark-up, how much covers the store's costs and how much is clear profit? Everyone has their own answers to these questions. But I suspect most of those answers are based on vague impressions and long-held prejudices rather than hard evidence.

When I was growing up we were always hearing about the depredations of "middlemen". The poor farmers got terribly low prices for their meat and other produce, but by the time that produce went through many hands to reach us in the city, the prices were sky high.

These days, we hear continually about the evil practices of the two big supermarket chains. They're busy screwing the life out of dairy farmers and other suppliers, just so they can use cheap milk and bread to lure us into their stores.

This may sound like a good thing for consumers beset by an ever-rising cost of living, but don't be fooled, we're told. The wicked retailers may be undercharging for a few staples, but they make up for it by overcharging for everything else. Then there are all the people discovering from the internet just how much lower prices are in other countries. More proof we're being ripped off.

In the hands of the media, it's a morality tale. The farmers and manufacturers are the good guys getting squeezed; the big retailers and other middlemen are the bad guys raking it in and doing us down.

It would be good to measure all these impressions against some hard statistical facts - facts supplied by an article in the latest issue of the Reserve Bank's Bulletin, on which I'll be drawing heavily.

Part of the problem is our lack of imagination. Many of us have only a vague idea of the role played by the businesses that operate between primary and secondary producers and you and me.

Most retail goods - including food and non-alcoholic drinks, clothing, footwear, electrical equipment, furniture and home appliances, and motor vehicles, but not "meals out" or takeaways - are produced in factories, whether locally or overseas.

The basic cost of producing those goods includes the cost of transporting them to wholesalers' warehouses, plus import duty where still applicable. Wholesalers incur costs in storing goods and transporting them around the country to retailers' stores, plus normal administrative costs. Retailers incur costs of rent, storage, display, finance and other costs.

Naturally, wholesalers and retailers employ many workers to help them carry out their role, not of making goods, but of distributing them into the hands of consumers across the nation. Indeed, the work of this "retail supply chain" accounts for about 7 per cent of the final value of all goods and services sold in Australia (gross domestic product) and about 10 per cent of total employment. So one worker in 10 is employed as a supposedly unproductive "middleman".

On average, the manufactured cost of the goods we buy accounts for about half the retail prices we pay. About 40 per cent of the prices we pay cover the costs incurred by wholesalers and retailers, with wage costs accounting for a bit less than 20 per cent and other costs for a bit more than 20 per cent.

That leaves the wholesalers' and retailers' net profits accounting for only about 10 per cent of the prices we pay, with about three-quarters of that going to the retailers.

Of course, these overall averages differ for different products. Whereas the gross profit margin (that is, before allowing for expenses) averages 50 per cent, it's closer to 60 per cent for clothing and footwear, a bit over 50 per cent for electrical equipment, a bit under 50 for furniture and appliances, about 40 per cent for food and drink, and just 25 per cent for motor vehicles.

Gross margins also vary according to the size of retail outlets and the speed at which stock turns over. Margins are higher in boutique stores than department stores, and higher in small convenience stores than big supermarkets, where the profit-making emphasis is on rapid turnover rather than high margins.

The Reserve Bank's detailed examination covered the figures for the nine years to 2007-08, though other checks suggest they haven't changed much since then. It found the production prices of locally manufactured goods rose quite strongly over the period. As well, the wage rates and other costs paid by wholesalers and retailers rose by more than 3 per cent a year.

Even so, the final prices of retail goods rose by only about 1 per cent a year. So much for the notion retailers have been getting greedier.

But how have they managed to turn costs rising by 3 per cent or so a year into retail prices rising by 1 per cent and do so without suffering any squeeze in their net profit margins?

Because, although business people are always assuring us there's nothing they can do but pass higher costs on to us, in truth there's a lot they can do.

One thing they've done is increasingly substitute cheaper imported goods for ever more expensive locally made goods. If that worries you, have a look at my little video on the website or iPad app today.

The other thing they've done is raise the productivity of their labour, with the volume of their sales rising a lot faster than the total hours of the workers they employ. They've invested in labour-saving equipment and facilities.

And note this: why have they being working so hard to limit their price rises? Because of the power of market forces - in this case, customers who don't like paying more.

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Economists have no lock on economic understanding

Many people don't realise the economics we hear from politicians, business people, economists and the media, morning, noon and night, is just one way of analysing how the economy works.

Almost everything we're told about what causes what is inspired by the "neoclassical" model. It's long been by far the dominant way of explaining why things happen and predicting what will happen, but it's not the only way. And it's far from infallible.

This conventional economics reduces all economic activity to that which happens within markets. It further narrows the operation of markets to the setting of prices, assuming movements in relative prices are the primary thing influencing the behaviour of producers and consumers.

It thus abstracts from the role of "institutions" - be they organisations, laws or conventions - in influencing market behaviour, so often leads economists to make policy recommendations that prove seriously misguided.

After the fall of communism, for instance, many economists urged the leaders of the formerly planned economies to switch to market-based economies in one big bang.

Since few people knew how to behave in a market economy, it was a disaster.

Only after economic activity had contracted massively did economists realise it was naive to assume that markets could be created out of thin air.

In the 1990s, the International Monetary Fund urged the emerging economies to open up to the free inflow of foreign capital. The result was the Asian financial crisis of 1997-98, when all the foreign capital flowed back out, leaving devastation in its wake.

Only then did economists realise that the developed economies were able to cope with swirling capital flows because of a raft of government-created institutions that had been developed over centuries: well-developed commercial law, with independent courts to enforce contracts; bankruptcy laws to deal with failed businesses; audited financial statements that were roughly believable, and so forth. Developing countries possessed none of these stabilising institutions.

Economic sociologists study the behaviour of markets, but put much emphasis on determining the role of norms of acceptable behaviour. For conventional economists to assume our behaviour in economic situations is heavily influenced by price changes but not by social norms is quite silly.

But for a good example of the way different analytical models can draw different conclusions about the same problem, consider an old economists' favourite: the "tragedy of the commons".

In situations where a piece of land is available for use by different farmers to graze their animals, it's likely to become overused and degraded. Similarly, common fishing areas are likely to be overfished, perhaps to the point where fish disappear. Common logging forests will be overlogged and laid waste.

Although the modern version of this ancient problem, that was used to justify Britain's "enclosure movement" many centuries ago, was first put forward by an ecologist, economists leapt on it with glee. It was clearly a problem of property rights.

Because no one owned the common area, no one had an economic incentive to look after it. Indeed, each individual had an incentive to get in and use as much of it as possible, as quickly as possible, before other individuals used it up.

So what was everyone's property was actually no one's property - and that was the essence of the problem. Many economists thought it obvious that the solution was to allocate private property rights over the commons.

Who they were allocated to, and how they were allocated, didn't matter much. What mattered was that once someone owned the asset, they would have the economic incentive to look after it and prevent its degradation.

In all probability they would continue to make it available to existing users, but at a price. That price would discourage those people from overusing it, while also providing the private owner with both the motive and the means to keep the asset in good repair.

Neat, eh? Of course, there were also some who saw the solution as having the government take over the common property, maintain it and allocate its use on some fair basis.

But there was one obdurate woman who, lacking an economics education, wasn't impressed by the economists' neat analysis of the problem and thought there might be another, better solution - if, indeed, it was a problem.

She was Elinor Ostrom, a professor of political science at Indiana University, who devoted much of her career to combing the world looking for examples where people had developed ways of regulating their use of common resources without resort to either private property rights or government intervention.

As The Economist records, she found forests in Nepal, irrigation systems in Spain, mountain villages in Switzerland and Japan, and fisheries in Maine and Indonesia. In all these cases people drew up sensible rules for sharing the use of the resource and combined to perform regular repairs. People who broke the rules were fined or eventually excluded.

"The schemes were mutual and reciprocal, and many had worked well for centuries," the magazine says.

For her pains, Ostrom, who died last month, was awarded the Nobel prize in economics in 2009, the first woman so honoured. Few economists had heard of her, or her model-busting work.

Why had this solution to the problem never been considered by economists?

Because of their model's implicit assumption that we only ever act as individuals, never collectively. We compete against each other, but we never co-operate to solve mutual problems.

And, since all the market's benefits come via competition, co-operation by producers is probably an attempt to rig the market, which should be outlawed.

The community pays a high price for allowing one model of how the economy works to dominate the advice we get and the way we think.

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Resources boom will lead to much bigger mining sector

A widespread fear - or maybe for some, a hope - is that the resources boom will evaporate someday soon. What will we do once it's over, a lot of people ask. Well, this week we got an answer: export at least twice the minerals and energy we do today.

You can divide the resources boom into three overlapping phases. The first phase is where the prices we receive for our exports of coal and iron ore shoot up to unprecedented levels because the world's exporters of those commodities are unprepared for the surge in demand from China and India as they rapidly industrialise.

The second phase is where our (and the world's) commodity producers seek to take advantage of those remarkable prices by expanding their production capacity as quickly as possible. At first the mining companies expand their existing mines, then they and others begin building new mines.

Much of the financial capital they require to fund this expansion comes from the retained after-tax earnings of the mining companies' shareholders (many of whom are foreigners). Much of the rest of the financial capital will be acquired from abroad. Much of the physical capital (mainly equipment) the miners install will be imported.

As part of the expansion, steps must be taken to ensure sufficient infrastructure exists to transport the minerals or natural gas to the nearest port by road or rail or pipeline, then loaded onto bulk carriers. Often this infrastructure is provided privately, sometimes it's provided by government.

The third phase is where the new production capacity comes on line and the volume of our exports starts to surge. But it won't just be us who are now exporting a lot more. The countries we compete with will also have been expanding their production capacity.

So even if you assume the demand for mineral and energy continues unabated - which is a reasonable expectation in this case - the global surge in supply can be expected to bring down the earlier sky-high prices.

Thus the prices we've been receiving for our exports are certain to fall back. Fortunately, however, this will occur as the volume of those exports is growing, thereby limiting the effect on the total value of our exports.

So, where do we stand in this process?

We've reached the point where, after a lot of global investment in new capacity, global supply has begun to expand and global prices have passed their peak and begun falling.

Thus our terms of trade - the prices we receive for our exports relative to the prices we pay for our imports - peaked in the September quarter and fell back in the two subsequent quarters. The terms-of-trade index (where 2009-10 equals 100) got to 130, but has since fallen by 10 per cent to 117.

Since it was the big improvement in our terms of trade that did most to explain the rise in our exchange rate, this deterioration in our terms of trade might explain why the dollar has fallen closer to parity with the US dollar. We can't be sure, however, because - as you might have noticed - a lot of other worries have been affecting global currency markets lately.

Similarly, although we can't be sure, most economists are confident global coal and iron ore prices won't fall back to where they were before the boom started, meaning our terms of trade will stay above their long-term average.

And, assisted by continuing strong capital inflow to Australia, the dollar will stay well above its post-float average of about US75?. (Meaning, of course, that life will stay uncomfortable for our other export and import-competing industries.)

This doesn't mean the second, investment phase of the boom is nearing its end, however. According to a Bureau of Statistics survey, the industry is expecting to spend a record $120 billion this financial year, up from $95 billion in the year just past.

Much mining investment comes under the heading of "engineering construction". It's expected to grow in real terms by more than 20 per cent in 2012-13 and by 9 per cent in 2013-14. The industry has committed to, or commenced construction on, more than half the fabled $456 billion resources-investment pipeline.

Note that much of the spending in recent times is on the development of liquefied natural gas facilities.

As for the third, export expansion phase, this week we got some new estimates from the Bureau of Resources and Energy Economics. It's expecting the volume of our total minerals and energy exports of about 700 million tonnes a year to more than double by 2025. And that's just the low-range estimate.

We now export about 400 million tonnes of iron ore a year. By 2025, this could grow to between 885 million and 1082 million tonnes. If so, our share of the world export market would go from its previous 30 per cent to between 45 and 55 per cent. Our main competitors are Brazil and West Africa.

At present we export about 20 million tonnes of natural gas a year, giving us just 2 per cent of the world export market. This could increase to between 86 million and 130 million tonnes by 2025, taking our market share to between 10 and 15 per cent. Our main competitors are Qatar, Russia and, in future, North America.

We are now exporting roughly 150 million tonnes of steaming (thermal) coal, giving us less than 20 per cent of the export market. This could rise to between 267 million and 383 million tonnes by 2025, taking our market share to between 23 and 33 per cent. Our competitors include Indonesia and, in future, Mongolia.

Our exports of coking (metallurgical) coal are roughly 150 million tonnes a year, but they could rise to between 260 million and 306 million tonnes. This would take our market share from 60 per cent to between 56 and 66 per cent. So there's a risk we lose market share to rivals such as Colombia.

All this growth isn't expected to much change the states' share of bulk commodity exports by volume. Western Australia has 60 per cent and Queensland has 22 per cent. But NSW has 15 per cent, leaving other states and territories with 3 per cent.

We'll be left with a mining sector whose share of national production (gross domestic product) well exceeds 10 per cent, making it bigger than manufacturing.

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House prices won't collapse, but won't take off either

For years when people at dinner parties worried about houses becoming too expensive for the younger generation to afford, I used to tell them not to worry: it was logically impossible for prices to rise to a level no one could afford. Why do I remind you of this? Because it's starting to look like I was right.

When prices are rising, and have been for many years, it's easy to conclude they'll go on rising forever. Even easier to conclude - as every real estate agent encouraged us to - is that house prices can only ever go in one direction.

As we're discovering, it turns out not to be true. According to Saul Eslake, of Bank of America Merrill Lynch, Australian house prices rose by 142 per cent between 2000 and their peak in late 2010, but in the 18 months since then have fallen by a national average of about 7 per cent. (In Sydney the fall's been 5 per cent; in Perth, 9 per cent, Melbourne 11 per cent, Brisbane 12 per cent.)

There's no shortage of people, particularly foreigners, who're convinced this increase went way beyond what the "fundamentals" of supply and demand could justify - a bubble, in other words - and it won't be long before the bubble bursts and prices come crashing down, as they have in the US and various other countries.

They may prove right, but I'm with Eslake, who argues it's unlikely. He estimates the present level of house prices is fully justified by the change over several decades of the two main factors determining the affordability of housing: household income and the level of mortgage interest rates.

The Australian median house price rose from 2.8 times average annual household disposable income in 1993 to four times in 2001. Since then it's been relatively stable. What allowed that multiple to rise so greatly was a "structural decline" in mortgage interest rates that occurred in the 1990s with the return to low inflation and the shift to the official interest rate being set by an independent central bank rather than politicians.

We could have used that fall in interest rates to pay off our homes much faster, or to increase our spending on other things. Instead we decided to use it to borrow more and move to a better house.

Because so many of us made that choice at pretty much the same time, we weren't all able to move to "better" (bigger, better appointed or better located) homes. Rather, the main thing we achieved was to bid up the prices of homes generally.

In the jargon of economists, we took that essentially once-only fall in the average level of mortgage interest rates - which Eslake estimates to have been about 4.5 percentage points - and "capitalised" it into the value of our homes.

Eslake argues house prices aren't likely to come crashing down because we have the income and borrowing capacity to afford the price of housing at roughly its present level, because we haven't been building more homes than the growth in the population justifies (in fact, we've been building too few), and because we haven't been borrowing against our homes to finance other consumption.

Eslake does predict, however, that house prices will rise much more modestly over the coming decade or two than they did in recent decades. Whereas they rose at the rate of 9.5 per cent a year during the noughties, he predicts rises averaging 3 per cent or 4 per cent a year in future.

Why? Because there won't be another, one-off, structural fall in the level of interest rates that greatly increases our capacity to borrow without increasing our monthly repayments. (Don't confuse the Reserve Bank's ups and downs in interest rates as it manipulates rates to manage the economy through the downs and ups of the business cycle - which get so much attention from the media - with the underlying average level of rates over a longer period.)

Without a structural shift in interest rates, house prices can't rise much faster than household incomes are growing. The indirect flow-through to households of the ever-rising prices we were getting for our mineral exports caused household disposable income to grow at an average rate of about 7.5 per cent a year over the past decade or so.

That compares with 4.5 per cent a year during the 1990s. Now commodity prices have stopped rising and are easing back, a more modest rate of growth is likely in coming years.

Which brings me back to where I started. The value of your home is easily determined: it's worth what you can find someone willing to pay for it. The value of homes generally can be no higher than what people generally are willing to pay and able to pay.

While it's always possible for prices to be higher than particular individuals can afford, it's impossible for them to be higher than most people can afford.

But it's surprising how much flexibility - room for give and take - there is in the system.

Many parents understand that, from their own privileged position as home owners, they have to assist their children to make the expensive step up to a home of their own.

For as long as enough parents see it that way, house prices will stay roughly where they are.

Were too many parents to be unwilling to help their kids make the step up, however, house prices would have to fall. This generation sells its homes to the next generation.

I take the present small falls in house prices as a sign the limits to affordability have been reached, and won't be exceeded.

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Why the banks haven't stuffed monetary policy

A new month, another meeting of the Reserve Bank board on the first Tuesday. Tomorrow, in fact. You beaut, another bout of speculation. Will they or won't they cut the official interest rate?

Thankfully, the speculation is a bit half-hearted this month. Having cut the rate two months in a row, most observers aren't expecting another cut this month.

So let's take the opportunity to discuss a more cerebral question: with the banks now going their own way on the interest rates they charge home buyers and business, does it still matter what the Reserve decides on interest rates?

In theory, it uses changes in its official interest rate to bring about changes in the market rates the banks charge households and businesses. It cuts rates when it wants to encourage borrowing and spending, and thus speed up the economy; it raises rates when it wants to discourage borrowing and spending, and thus slow down the economy.

It manipulates interest rates so as to achieve its inflation target - to hold the inflation rate between 2 and 3 per cent, on average, over the medium term - while also keeping unemployment low. Economists call this manipulation "monetary policy". But with the banks doing their own thing, is monetary policy still effective? If you listen to some bank spokesmen, moves in what the market prefers to call the "cash rate" no longer have a big effect on the decisions banks make about the rates they charge.

Don't you believe it. They're trying to justify their actions, not explain how interest rates work.

The cash rate is the cost of borrowing overnight in the money market; the rate at which the banks lend to each other. The Reserve keeps the cash rate under very tight control by means of "open market operations" - buying or selling second-hand government bonds to the banks.

Between 1999 and 2007, it was easy to see how the Reserve's ability to change the cash rate led to changes in the rates the banks charged on home mortgages and borrowing by businesses: any change in the cash rate - whether up or down - was soon passed on by the banks to their customers.

But from 2007, in the early days of the global financial crisis, that simple relationship broke down and the banks began making "unofficial" rate changes, usually in association with official changes. Why did things change? Because of the money-market disruption and changed relationships brought about by the crisis.

The cash rate is regarded as the risk-free rate of borrowing overnight and it thus forms the "anchor" for all other short-term and variable interest rates in the market. The other rates will usually be higher than the cash rate, with those other rates' margin (or "spread") above the cash rate, reflecting the extra reward to lenders for the various risks they have taken on: the "credit risk" (of not being repaid), the "liquidity risk" (of being unable to sell the debt security without loss because of limited demand for that security) and the "term risk" (of having your money tied up for a longer period).

During the period up to the start of the financial crisis, all these risks, and hence margins, stayed steady. So a change in the risk-free anchor could be passed on mechanically to the banks' borrowers.

But the crisis made people in various international markets a lot more conscious of the risks they were running, thus increasing the spreads they were demanding. Some markets actually ceased to operate for a time.

This wiped out our banks' chief competitors, the mortgage originators, which ended up being bought out by the banks. Later on, the prudential supervisors and the rating agencies decided our banks had made themselves too vulnerable to events such as the GFC by relying too heavily on short-term borrowing from overseas money markets.

So the banks began trying to lengthen the maturity of their foreign borrowing and also began competing with each other to attract more domestic deposits, particularly term deposits.

These changed conditions meant that, though the cash rate - the risk-free anchor for interest rates - remained the largest single influence over the banks' cost of funds, that cost was also influenced by other factors, such as the changing spreads required by foreign long-term lenders to our banks and by the higher rates needed to attract more term deposits from Australian savers.

Anxious to preserve their existing (very generous) "net interest margin" - the difference been the banks' average cost of funds and the average rate they charge their borrowers - the banks have become emboldened to pass any increase in their cost of funds on to their customers independent of changes in the cash rate.

After the Reserve's cut in the cash rate of 25 basis points in June, the banks decided to pass on about 20 or 21 basis points, thus demonstrating that the cash rate remains the dominant influence over market rates (in this example, 84 per cent), notwithstanding the change in the banks' circumstances and behaviour.

The more fundamental reason the effectiveness of monetary policy has not been reduced is the Reserve's repeated statements that the interest rates it cares about are those actually being paid by households and businesses, not the cash rate. So it makes whatever changes to the cash rate are necessary to get mortgage rates and business borrowing rates where it wants them to be.

Many people are highly disapproving of the banks' efforts to preserve their profitability by increasing the spread between the cash rate and the mortgage rate. But don't confuse the question of whether you approve of the banks' behaviour with the question of whether monetary policy has become less effective. It hasn't.

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