Economists should learn some geography

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

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

Behavioural economics and economic sociology attempt to correct this deficiency.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Big business now calling the economic shots

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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ALL YOU NEED TO KNOW ON THE TRICKY TOPIC OF PRODUCTIVITY

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

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

                                                                     Paul Krugman, The Age of Diminishing Expectations (1994)

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

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

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

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

Definition

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

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

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

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

Importance

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

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

Measurement

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

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

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

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

Scorecard

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

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

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

Explaining the deterioration in MFP

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

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

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

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

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

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

Bad productivity improvements and good productivity declines

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

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

Productivity, profits and wages

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

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

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

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

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

Productivity and employment

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

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

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

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

Productivity and immigration

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

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

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

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

Productivity and other advanced economies

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

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

Productivity and recessions

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

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

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

Productivity and microeconomic reform

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

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

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

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

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

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

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

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Econocrats advise false economy

Joe Hockey and Tony Abbott shouldn't take all the blame for the low quality of the measures in the budget. I suspect they're victims of poor advice from the econocrats of Treasury and Finance.

Gary Banks, former boss of the Productivity Commission, says the public service's role is to inform policy choices. If so, it did an unimpressive job of informing an inexperienced government on the best way to exploit the unique political opportunity offered by the Coalition's very first budget.

We can never know exactly what advice passed between the bureaucrats and their masters, but it would be an unusual budget whose measures didn't arise from options provided by the presumed experts.

And a comment by Laura Tingle of The Australian Financial Review offers a clue: "Former Labor ministers were genuinely surprised after the May 13 budget that the new government had simply picked up the same raw policy proposals the public service had been serving up for years and included them in the budget ... It seemed no one in the new government ... recognised these as policy chestnuts from the bureaucracy's bottom drawer."

If that's right, it's an indictment of the bureaucrats' intellectual laziness and lack of expertise. It's the 21st century, but these people have sat for decades learning nothing but "here's where you could cut, minister".

A huge proportion of the spending on two of the nation's biggest and fastest-growing industries, education and health - industries whose performance has major implications for productivity and social wellbeing - passes through the federal budget, but all the budget bureaucrats have to offer is a list of things you could chop.

Since the budget measures focused almost exclusively on the spending side, and since those measures had the smell of the bookkeeper rather than the economist (economists are trained to think about subsequent, not just immediate, effects), I suspect it's Finance more than Treasury that's responsible for such a dismal performance.

What we needed were sophisticated initiatives aimed at raising the efficiency with which public services are delivered to the public.

What does the empirical literature and the experience of other governments tell us about what works and what doesn't? If Finance and Treasury aren't expert on this, why aren't they?

What we got instead were crude spending cuts - or, more often, cost-shifting. A high proportion of the savings will come merely from shunting more of the cost of education and health onto graduates, patients and the states. How much thought went into cooking that up?

The right answer to the growing cost of the Pharmaceutical Benefits Scheme, for instance, is to drive harder bargains on generics with the big foreign drug companies (which pose as Medicines Australia) and the chemists, and to force harder choices on the medicos who advise on which new drugs should be listed by giving them an annual spending cap.

So what did we get? A $5-a-pop increase in the already high general patient co-payment which, in any case, is indexed, with a smaller rise for pensioners. Could laying it on so thick discourage people from filling their prescriptions, thus worsening their health and eventually adding to public spending on healthcare?

Who knows? Who cares? No one in the budget bureaucracy, it seems. If the measure makes things worse rather than better, worry about that in a later budget. "I know, minister, let's whack up patient co-payments again. Tell 'em health costs are unsustainable."

It's a similar story with Medicare. Health economists have devised various ways of achieving greater efficiency, particularly in hospitals, but who's bothered about that? Why tax your brains when you could just chop spending on preventive health programs, slash grants to the states and introduce a $7 co-payment for GP visits and tests?

The co-payment will shift costs to the states and add to ill health and costs down the track, but who's worried? It will be costly to administer, but less so when we advise ministers to whack it up again in a few years' time because health costs are still rising "unsustainably".

But the most mindless false economy is surely the now 2.5 per cent annual "efficiency dividend" cut imposed on the budgets of government departments. Treasury complains it's had to cut staff numbers by one-third just since 2011. Finance must be suffering, too.

Wouldn't it be ironic if the budget bureaucrats were among the chief victims of their failure to give the pollies better advice on spending control? By now, of course, this would be their chief excuse for continuing bad advice. "We don't have the resources, minister."

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Teenagers suffering most from slow growth

I hate to say it, but the spectacular events that hit the headlines aren't necessarily the things most worth worrying about. The big news on the economy this week was the spectacular jump in the unemployment rate from 6 per cent to 6.4 per just during July. Not a big worry.

Question is, what does it prove? That the economy fell into a hole around the middle of the year? Doubt it. There's little other evidence that it did and a lot that it didn't.

That the slow upward creep in unemployment we've been seeing for about two years may have accelerated? Doubt that, too. Again, the other economic indicators aren't pointing that way.

(Indeed, some economists have been wondering if unemployment was close to peaking. So far this year employment has grown by an average of 15,600 jobs a month, compared with just 5100 a month last year.)

That the unemployment figures are volatile from month to month and this is an unexplained statistical blip that should be corrected next month? Seems a bit too big for that.

Truth is it's hard to know what the problem is. Easier to be sure when we've seen another month or two's figures.

But my guess is it's a once-only upward step in the measured rate of unemployment, caused by a seemingly small change in the questions that people in the Bureau of Statistics' monthly survey are asked so as to ascertain whether they've been "actively" seeking a job if they don't have one.

The change - made partly because of the switch to searching for jobs on the internet rather than at Centrelink - seems to have led to more people being classed as unemployed and fewer as "not in the labour force".

If this guess proves right, it's not so worrying. It doesn't change reality, just the way we measure it. In any case, we've long known that the official measure of unemployment is very narrow and understates the extent of the problem.

That's why the bureau publishes every quarter a broader measure of unemployment, which takes the official unemployment rate and adds the under-employed - people with jobs who aren't working as many hours a week as they'd like to - to give the "labour force underutilisation rate".

The figures for May show narrowly measured unemployment of 6 per cent, and an underemployment rate of 7.5 per cent, to give a broader measure of 13.5 per cent.

Less spectacular than this month's jump in the official rate but, to me, more worthy of worry is news that hasn't hit the headlines: the rapid worsening in teenage unemployment.

Whereas so far this year the trend rate of overall unemployment has risen by 0.2 percentage points, the trend rate for people aged 15 to 19 has risen by 2.8 percentage points to 19.3 per cent.

Note, this doesn't mean almost one youth in five is unemployed. Most people that age are in full-time education, so aren't in the calculation. Turns out about one in 20 of all 15 to 19 year-olds is unemployed and looking for a full-time job.

Many people have it in their heads that unemployment rises because people lose their jobs and employment falls. That's true only in recessions. It's rare for employment to fall - it fell only briefly even during the global financial crisis.

No, the main reason unemployment rises outside of recessions is that the economy isn't growing fast enough to employ all the extra people joining the labour force from education, as immigrants or as mothers rejoining.

That's what's been happening over the past two years. And young people - particularly those who leave school or training too early - have borne most of the burden of insufficient job creation. We should be doing much better by them than Work for the Dole and denying them benefits for six months to keep them hungry.

But there's nothing spectacular about this quiet suffering, so it doesn't hit the headlines. Much better to scandalise over factory closures, which surely signal the end of the world. So let's look at the facts on retrenchment, courtesy of a Bureau of Statistics study.

About 2 million people left their jobs over the year to February 2013 (the latest period for which figures are available). About 60 per cent of these left voluntarily and 21 per cent left because of their illness or injury, leaving 19 per cent - 380,000 - who left because they were retrenched.

That's a rate of retrenchment of 3.1 per cent. The rate hit 4 per cent in 2000, but then fell to a low of 2 per cent in 2008, just before the global financial crisis, then increased sharply to 3.1 per cent in 2010, where it has pretty much stayed since.

Over the year to 2013, all industries experienced retrenchments, but the most were in construction, 65,000; retailing, 40,000; and manufacturing, just under 40,000.

But the number of people employed in particular industries differs a lot so, judged by rate of retrenchment, utilities and construction come equal first with 6.4 per cent, then mining with 6 per cent, pushing manufacturing into fourth place with 4.5 per cent.

The rate of retrenchment is consistently higher for men because men tend to dominate those industries where retrenchment rates are higher, whereas retrenchment rates tend to be lower in industries dominated by women workers, such as education and health.

The likelihood of being retrenched falls as your level of educational attainment rises. We're more conscious of older workers being laid off but, in fact, retrenchment is greatest among workers aged 25 to 44.

And what happens to people who're laid off? For those retrenched over the year to February 2013, half were back in jobs by the end of the year, leaving 29 per cent unemployed and 21 per cent not in the labour force.

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Modellers bamboozle over cost of renewable energy

There's a lot of public support for the renewable energy target, which requires electricity retailers to get 20 per cent of their power from renewable sources by 2020. But now the country's being run by climate change "sceptics", let's get with the program. Forget the threat of climate change, stop worrying about your grandchildren and focus on what matters most: what this do-gooder scheme is doing to your cost of living.

Although before the election Tony Abbott professed support for the target, since the election he has instituted an expert review of it, headed by businessman Dick Warburton, former chairman of Caltex and prominent "sceptic".

The review commissioned a leading firm of economic consultants, ACIL Allen, to undertake modelling on the future effects of the target.

The preliminary report found that, between 2015 and 2020, the target would increase the average household electricity bill by $54 a year - a tad over $1 a week. This five-year average, however, conceals the estimation that the cost of the scheme will fall as each year passes.

So by 2020 itself, the increase will have reduced to just $7 a year. By the end of another 10 years, in 2030, the scheme is estimated to be actually reducing average household electricity bills by $91 a year, or $1.75 a week.

It's common sense that requiring electricity retailers to buy a certain proportion of their power from more expensive renewable sources - mainly wind power, but also solar - would add to the cost of their power, with the extra cost being passed on to consumers.

So why has ACIL Allen's modelling concluded the target will add to the price of electricity initially, but eventually subtract from it? The short answer is because electricity pricing is a complicated business.

It turns out that adding to the supply of renewable energy available reduces the wholesale price of electricity. This is because the price being paid for energy being put into the national electricity grid by particular generators varies minute by minute according to the balance of supply and demand.

In the middle of the night, when little power is being used, the wholesale price is very low. But on a cold evening - or, more likely these days, a very hot afternoon - the wholesale price can be stratospheric.

The trick to renewable energy is that it tends to be available when the demand for electricity is high. Experience around the world confirms the Australian experience that renewable energy does a great job of reducing spikes in wholesale prices on very hot and very cold days.

Another part of it is that though it costs a lot to build wind and solar generators, once they're built there are few "variable" costs. Wind and sun are free; coal and gas aren't. So the renewable generators offer to supply power to the grid at very low prices and this lowers the prices the coal and gas generators are able to ask for.

But none of this changes the fact that the electricity retailers have to pay for the "renewable energy certificates" that the target scheme requires them to buy. These certificates reduce the capital cost of setting up the wind and solar generators whose operations then reduce the wholesale cost of power.

So it turns out the renewable energy target scheme has the effect of reducing the wholesale cost of electricity while also adding to the costs of the electricity retailers. ACIL Allen's modelling suggests that, for the next five years, the extra retail cost will exceed the saving in wholesale costs, but after that the saving will exceed the extra cost.

See what this means? The case for saying we must get rid of the renewable energy scheme because it's adding too much to the living costs of struggling families has collapsed.

But there's where the story takes a twist. Modelling of the future cost of the renewable energy target, published by an equally prominent firm of economic consultants, Deloitte, comes to opposite conclusions.

Deloitte's modelling accepts that the renewable energy scheme is reducing wholesale costs, and roughly confirms ACIL Allen's finding about the higher cost to household customers until 2020. But whereas ACIL Allen expects the scheme to start reducing household costs after that, Deloitte expects the cost to stay positive until 2030, causing household bills to be between $47 and $65 a year higher than if the scheme was scrapped.

Why have two leading economic consultants reached such opposing conclusions? Perhaps because Deloitte's modelling was commissioned by the Chamber of Commerce and Industry, the Business Council and the Minerals Council.

Deloitte doesn't conceal that its modelling is in reply to ACIL Allen's. Would it surprise you if the fossil fuel industry wanted to see the renewable energy target abolished and was alarmed to know that modelling commissioned by the review had demolished the argument that continuing the target would add to people's electricity bills? Now the review will be able to pick whichever modelling results it prefers.

How did Deloitte reach such different results? By feeding different assumptions into its model. It seems to have assumed the cost of wind farms won't fall over time (which it probably will), whereas the price of gas for gas-fired generators won't rise much (which it already has).

Regrettably, economic modelling has degenerated into a device for bamboozling the public.

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Why no one is backing the budget

A big reason Joe Hockey isn't getting much support from independent observers like me in his battle to get the budget through the Senate is that so few of his contentious measures are worth fighting for.

If he were facing opposition from vested interests struggling to protect their privilege, or even just unthinking populism from the punters, it would be a different matter.

For a bit I thought I'd be in the trenches with him defending a plan to impose a temporary deficit levy on individuals with incomes above $80,000 a year but, as we now know, his boss insisted on lifting the threshold to a far-less-contentious $180,000 a year.

What would have made the lower threshold defensible is the inconvenient truth that so much of our present distance from budget surplus is explained by the folly of eight tax cuts in a row, the savings from which were skewed in favour of higher income-earners. This would have clawed back a bit of it.

It's remarkable anyone could put together a budget at once so unpopular and so lacking in Paul Keating's "quality cuts". Who did Hockey imagine would join him at the barricades apart from the mindlessly partisan commentators? (Even they haven't been particularly vociferous - although the government hasn't raised much of a banner to rally behind.)

In my initial assessment I said "I give Joe Hockey's first budgetary exam a distinction on management of the macro economy, a credit on micro-economic reform and a fail on fairness".

Nothing wrong with the F, and the D on macro management has stood up well. The decision to announce a lot of measures that didn't take much effect until the last year of the forward estimates, 2017-18, was a clever combination of macro-economic good sense - nothing to gain by hitting demand while it was expected to be weak - and political necessity.

By delaying the start of so many measures until after the next election Hockey was able to claim the budget didn't really break all the election promises Tony Abbott made when pushing his contention that a "budget emergency" could be fixed without pain.

It's not part of my religion to insist politicians keep irresponsible promises they should never have made. But that's not to say such blatant promise-breaking carries no political price. After all the fuss Abbott made about "Ju-liar" Gillard and his pretence about restoring trust in politicians, my guess is the price his government is paying is high. The pity is he could have won comfortably without such dishonesty.

On closer inspection, my C for micro reform was badly astray. Should have been an M for missed opportunity. There was a lot of cost shifting, but precious little that could be claimed to increase the efficiency with which the government delivers its many high-cost services or to reduce rent-seeking by private industries.

The greatest disappointment was that, after making a good start in eliminating handouts to the car makers and refusing to bail out fruit canners, Hockey dropped the ball on business welfare, thus leaving all his talk of ending "the age of entitlement" looking like nothing more than a shameful attack on the poor and disadvantaged.

One honourable exception was the decision to remove the always-indefensible subsidy to locally produced ethanol. Another was the plan to resume indexing the fuel excise.

Removing the carbon price involved allowing fossil-fuel industries to continue imposing external costs on the rest of the community and the intention to abolish the mining tax involves allowing much receipt of economic rent by foreigners to go grossly under-taxed. That's efficient?

Add to that the failure to remove the fuel excise credit, which constitutes a favour to miners and farmers but no one else, and you have to ask what hold the big three mining companies have over this government.

Similarly, take the cutting back on the age pension while doing nothing whatsoever to curb the excesses of the concessional tax treatment of superannuation, combine it with watering down the Future of Financial Advice Act despite the presence of gross information asymmetry, and you have to ask what hold the big four banks have over this government.

On its face, you could have expected the "deregulation" of university fees to bring significant gains in efficiency - but only if your understanding of economics had progressed no further than 101. To take a relatively small number of government-owned and still highly regulated agencies with a monopoly over credential-granting, allow them to set their own fees and then imagine an adequately competitive "market" would emerge isn't economics, it's magical thinking.

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Chinese economy overtaking US and getting more like it

It isn't so many years since I used to berate the denizens of the financial markets for their lack of interest in the economy that had so much influence on ours: China. How things have changed. So has China.

After averaging growth of 10 per cent a year for 30 years, China's economy is now struggling to achieve its reduced target of 7.5 per cent. The financial market participants' role has been to watch on with concern.

And this week comes news that, though the International Monetary Fund sees China coming close to target this year, it expects it to slow to 7.1 per cent growth in 2015 and slow further in following years.

More surprisingly, the fund says that China should slow down to give it a chance to work on its big problems, rapidly growing debt and a rapidly contracting real estate market. Fumble those and growth could be even lower.

But while so many of us have been so focused on China's difficulty maintaining its rate of growth, we've lost sight of how big it is and how fast it's still growing compared with the rest of us.

Compared, say, with the world's biggest economy, the United States. Except that, according to the calculations of Euromonitor International, China will overtake the US this year. That's when you compare the two economies using "purchasing-power parity", which makes allowance for the fact that one US dollar buys a lot more in China than it does in the land of the free.

With China biggest and the US second, then come India, Japan, Germany, Russia and Brazil. We come in at 17th, not far behind Indonesia. The world certainly is changing.

Of course, the Chinese and American economies remain very different. China is big because of its much bigger population - 1.4 billion versus 300 million. Its income per person remains a fraction of America's. A not unrelated fact is that the US's productivity (measured as gross domestic product per worker) is more than nine times higher than China's.

And the two countries' industry structure is also very different. Agriculture contributes 10 per cent to GDP in China but just 1 per cent in the US. But get this: it accounts for almost a third of the workforce, compared with just 1.4 per cent in the US.

Manufacturing makes up 30 per cent of China's GDP, but only 13 per cent of America's. That tells us a lot about why China's rise, and the growth in its exports of manufactures, has affected so many other countries as well as maintaining downward pressure on world prices.

But the biggest difference between the two economies is their relative emphases on consumption and investment. Euromonitor International estimates that this year private consumption will account for 68 per cent of GDP in the US, compared with 37 per cent in China.

Here, however, we get to the really important news: the Chinese authorities have embarked on a process of "rebalancing" the economy, increasing consumer spending and domestic demand and reducing the roles of exports and investment in heavy industry.

The Economist notes that consumer spending has already begun its expansion, with its share of GDP rising from less than 35 per cent in 2010 to more than 36 per cent last year. And this year it has accounted for more than half the growth in GDP.

A big reason for stronger consumer spending is rapid growth in wages. Get this one: over the five years to 2013, real wages in manufacturing rose by about 2 per cent in the US, but by 45 per cent in China. As always happens, the benefits of economic development do flow eventually to ordinary workers.

This strong growth in consumption involves faster growth in the services sector, with manufacturing's share of GDP having peaked at almost a third in 2007.

This structural change means people following the ups and downs of the Chinese economy ought to be following a different set of indicators, as Peter Cai of China Spectator noted last week with help from Guan Qingyou, an economist at Minsheng Securities.

Cai says the main reason Chinese policymakers care so much about the rate of growth in GDP is their belief that the economy needs to grow by at least 7.2 per cent to absorb 10 million new entrants to the labour market each year.

But this correlation has been breaking down since 2010. Slower growth in GDP has not led to weaker job creation. Gaun suggests this is because the expanding services sector has a greater capacity to absorb new job seekers.


More fundamentally, China seems to be approaching its "Lewis turning-point", where a developing country runs out of its supply of surplus rural labour. This would also help explain the rising real wages.

Financial market participants focus on the growth in "industrial production" (manufacturing, mining and utilities) as a predictor of GDP growth, and on the manufacturing PMI (purchasing managers' index) as a predictor of industrial production.

But Cai says the strong correlation between industrial production and GDP is breaking down because the services sector is growing a lot faster than the industrial sector. Last year, for instance, the services sector contributed 47 per cent of the annual growth in GDP, whereas the industrial sector contributed less than 40 per cent. So, it's better to focus on the services sector PMI.

A big problem for China-watchers is that you don't know how much faith to put in official statistics. Earlier in his career, Premier Li Keqiang let it be known that he, too, had his doubts. So he focused on railway freight volumes, electricity consumption and bank lending as offering a better guide.

Now others have developed a "Li Keqiang index". But here, too, Guan argues that its reliability has declined, because of changes in the structure of industrial electricity use and changes in financing. China is changing.

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