EXPLORING STRUCTURAL CHANGE IN THE AUSTRALIAN ECONOMY

Comview 2015

Big changes in the structure of our economy have been happening before our eyes in recent years. But you well know - and each of your students needs to learn - that there’s nothing new about structural change. It may move faster in some periods than others, but it has been happening continuously in Australia since white settlement. It’s fascinating to trace changes in the structure of our economy, but it’s also illuminating, helping improve our understanding of the economic development process. In what follows I’ll be quoting extensively from the 2014 Australian Industry Report, produce by the chief economist of the federal Department of Industry, Innovation and Science.

What is structural change?

Structural change refers to shifts in the distribution of output, investment and employment across industries or regions. It refers to medium to long-term changes, not short-term changes attributable to the economy’s movement through the business cycle.

Structural change reflects the collective responses of individuals and firms to changing relative prices. Without structural adjustments, economies cannot respond to changes in relative prices, and therefore can’t achieve optimal allocation of resources under new conditions. The decade-long mining boom, for instance, would not have been possible without a rapid reallocation of resources towards that industry and away from other, less profitable industries.

Structural change is a continual process as relative prices are constantly fluctuating and economic resources constantly flow into and out of industries to take advantage of this. To show the economy’s constant state of flux, in the 12 months to February 2013, more than a million workers changed jobs, 9 per cent of the workforce. Of these, about 600,000 changed industry and about 460,000 changed occupation. Similarly, almost 240,000 new businesses entered the economy and about 300,000 businesses left the economy. The net effect of this constant flux is an ever-changing structure of the economy. The creation of new businesses and the decline of less competitive businesses are key to the economy’s long-term growth.

Prices change a lot more quickly than resources are able to move, however. Workers take time to respond to changes in relative wages because it can be difficult to relocate, or because it takes time to reskill and change occupations. Similar barriers effect the timely adjustment of capital and land use. These barriers can lead to unemployment and other inefficiencies such as idle machinery and equipment, which can have costly economic and social consequences. If adjustment occurs as a result of a short-term shock rather than a longer-term trend, the economy can take time to re-adjust and some businesses may not be able to return to their industry as quickly or easily as they left. So structural change is beneficial, but it does have costs. It may have adverse consequences for individuals, particularly those not easily able to move between industries, and so could lead to long-term unemployment. But it may also benefit workers able to take advantage of the new opportunities it offers.

Drivers of structural change

The main drivers (or sources or causes) of structural change are new technology, globalisation, consumer preferences and government policy. We’ll discuss these in turn.

Technology. Technological change is a basic driver of productivity improvement and economic growth. It has played a major part in globalisation, thanks to advances in transport and communications. In turn, globalisation exposes countries to more competition, which leads to a greater number of technological advances.

Technological change includes the development of new products, improvements to existing products and improvements to the processes by which products - services as well as goods - are produced and delivered to customers. So while much technological advance comes via machines or software, some comes via new ways of organising work in factories and offices.

Closely tied with technological change is the diffusion of knowledge, which determines how quickly and efficiently new technology emerges and can be adapted by industry for various purposes. This, in turn, can result in changes in the skills required of workers. Both the pace at which new technology can be adapted and the degree to which labour can be shifted between industries can alter the competitiveness and performance of firms. It’s the behaviour of firms that ultimately drives structural changes in the economy.

Technological change has driven structural change across the economy in a number of ways. Developments in computers, for example, have increased the range of occupations that can be automated, while improved communications and transfer of data have allowed transactions to occur over greater distances. These developments have allowed a greater variety of services to be exported without the need for the physical movement of people between countries.

Globalisation. Globalisation refers to the increasing connections between economies and between particular markets within each of those economies. In recent decades this process has been driven by a combination of technological advances - which have reduced transport costs and improved flows of information - and changes in government policies that have reduce barriers to trade, flows of capital and workers’ movements between countries.

In Australia, effective rates of protection of locally-made manufactured goods have fallen from 35 pc on top of production cost in the late 1960s to less than 5 pc today. Freight and insurance costs for imported goods have fallen from 8 pc to 5 pc since the late 1980s. Over the past two decades, Australia’s international trade (exports plus imports) has increased from 26 pc of GDP to 47 pc. But increasing international linkages also mean our economy is more exposed to international shocks.

Consumer preferences. Changes in consumer preferences also induce changes throughout the economy. As real incomes rise over time, households tend to spend the increase differently to the pattern of their existing spending. The increase goes disproportionately to luxury goods (including leisure activities, travel and fine dining) or to superior goods (such as health, education and housing) and “positional goods” (goods and services that demonstrate your higher social status). The biggest change in consumer preferences, therefore, has been slower growth in spending on goods and faster growth in spending on services. Since the beginning of the 1960s, the proportion of household disposable income spent on goods has fallen from 49 pc to 27pc, while the proportion spent on services has risen from 37 pc to 63 pc (with household saving falling from 14 pc to 10 pc).

As well, the ageing of the population is changing the composition of consumer spending. Over the past four decades, the median age of the population has risen from 27 to 37 years.

Government policy. All government policy potentially affects the sectoral composition of the economy, including by its effect on relative prices. Policy changes may have the effect of driving structural change or influencing the way or extent to which it occurs - eg the state governments’ response to the advent of Uber. Sometimes policy is motivated by a desire to prevent structural change.

Changes in the composition of government spending will affect the allocation of resources in the economy and thus its industry structure. Industry policy is obviously intended to affect the structure of industry. Even a policy to put a price on carbon is intended to bring about structural change, with more growth in renewable-energy industries and contraction in fossil-fuel industries.

The move from centralised wage-fixing to bargaining at the enterprise level has allowed relative wages to adjust more efficiently across industries and regions and given workers a stronger price signal of the relative demand for skills. It has also helped to prevent the wage inflation that has limited the gains from commodity price booms in the past.

The long-term pattern of structural change

The pattern of structural change in Australia over the past century or more is similar to that experienced in other developed countries. Stage one: pre-industrial economies are dominated by agriculture.

Stage two: productivity improvements due to technological advances free up resources, particularly labour, that were producing food to work in other industries, as less labour is required to feed the population. This results in the long-term decline of agriculture and the rise of manufacturing.

Stage three: as economies further modernise, manufacturing declines and services emerge as the dominant sector. This is typically a result of a more than proportionate change in demand from goods to services as incomes increase.

In Australia, the share of output from agriculture fell from over a third in the 19th century to just 3 pc in the 2000s. Similarly, the share of manufacturing output and employment fell by more than half between the 1960s and 2000s - output falling from 26 pc to 12 pc and employment falling from 26 pc to 11 pc. While services already accounted for about half of output in the 19th century, their share had grown to 59 pc by the 1960s and to 78 pc by the 2000s.

Note that a decline in a sector’s share of total output or employment may or may not imply an absolute decline in its output or employment. Despite the dramatic decline in agriculture’s share of total output over the past century, the quantity or volume of its output has continued to grow, by a factor of six. Never in human history have we feed so many mouths with so few farm hands. So agriculture’s share of the economy has declined not because it has been contracting, but because other industries have grown faster than it has.

Recent structural change in Australia

Mining. The resources boom, which lasted about a decade from the early noughties, had big effects on the business cycle, but nonetheless constituted a major and lasting change in the structure of our economy. This is because the boom in the prices we received for our exports of coal and iron ore prompted a huge expansion in our capacity to produce minerals and energy, including natural gas. Over the decade to 2014, mining’s share of total output doubled to 10 pc - probably the highest it’s been since the days of the gold rush.

You might expect an industry’s share of total output to be similar to its share of total employment, but this isn’t always the case. It depends on the extent to which its production is labour-intensive or capital-intensive. Mining is our most capital-intensive industry, so although its share of total output has doubled to 10 pc, its share of total employment has increased only from 1 pc to a little more than 2 pc.

Our other capital-intensive sectors are the other goods-producing industries, agriculture and manufacturing. Continuous advances in labour-saving technology have made them progressively more capital-intensive. It follows that the services sector accounts for most of our labour-intensive industries.

Manufacturing. Manufacturing’s shares of total output and total employment have been decline since the mid-1960s, with the share of employment falling faster than the output share because of computerisation. Note that, despite an absolute fall in its employment, the absolute quantity of manufacturing output continued growing until 2008. This, of course, is evidence of the industry’s ever-improving labour productivity. From 2008 on, the exceptionally high exchange rate caused by the mining boom greatly reduced the industry’s international price competitiveness, causing its output to fall in absolute terms and its declining shares of output and employment to accelerate. It remains to be seen to what extent the industry recovers now the exchange rate has returned to more comfortable levels.

Manufacturing employees are generally less geographically mobile than in other industries. Even so, manufacturing in regional areas has demonstrated considerable capacity to adjust in the face of the recent decline in employment. Employment outcomes for automotive workers have been better than feared. More broadly in manufacturing (and other declining industries), workers were mainly able to transition smoothly to new employment, as unemployment among these workers was not significantly higher than across all industries. Over the five years to 2011, the largest proportion of workers who moved into mining came from manufacturing - about 18,500 of them.

Despite impressions to the contrary, manufacturing remains an important part of the Australian economy, producing about $100 billion-worth of output each year and so making it the sixth biggest industry. It still employs more than 930,000 workers, making it our fourth largest employing industry. And not all parts of manufacturing are declining. The food, beverage and tobacco industry increased its employment by nearly 50,000 over the decade to 2012, making it the largest employer in the sector. Job losses have been greatest in textiles, clothing and footwear, and machinery and equipment manufacturing.

The relative decline of manufacturing can be attributed to various factors as well as reductions in import protection: increased competition from low-cost countries such as China and India and a shift in domestic consumer preferences towards services.

Manufactures have accounted for about 80 pc of the value of Australia’s total imports over the past four decades, a sign of our lack of comparative advantage in this sector.  About half these imports come from other OECD countries, with China accounting for about a quarter.

Services. The Australian economy is transitioning to a knowledge-based economy. This implies a smaller role for primary and secondary sectors and an even greater role for services in the economy. As well, a richer and older population is demanding more health care, more tourism and more education.

This shift to services is associated with changes in the skill and education levels of employees. Areas of employment growth are dominated by tertiary qualified workers, while employment losses are concentrated among those without post-school qualifications. The long-term structural shift towards service industries has resulted in a vast increase in highly skilled occupations, such as professionals (accountants, lawyers, engineers etc) and managers. This suggests that the structural shift towards services has necessitated a transition to an increasingly highly-skilled workforce. The resulting increase in demand for highly skilled workers can also be traced back to technological change. The rise of computer technology, for example, has led to an increase in demand for workers with the skills to use and maintain them. This is known as skill-biased technological change.

Structural change by state

Just as the industrial structure of the Australian economy is always changing, so its spatial structure across the continent is always changing. Increases in population cause increases in economic activity, but increases in activity in particular industries also attract higher population. There is much internal migration between Australia’s six states.

The oldest states - NSW and Victoria - have the biggest populations and shares of the national economy, but the younger states - particularly Queensland and Western Australia - have had the fastest rates of population and economic growth in recent decades, meaning their shares of the national population and economy are growing at the expense of the other states. As we were reminded by the resources boom, Western Australia and Queensland also enjoy a greater natural endowment of minerals and energy. This has left South Australia and Tasmania’s shares of the national population and economy small and getting smaller. They don’t have a lot of minerals, are suffering from the decline of manufacturing and aren’t at the centre of the growing business services sector.

I now turn from quoting the Australian Industry Report to quoting heavily from an article about The Economic Performance of the States in the March quarter, 2015, issue of the Reserve Bank’s Bulletin.

Over the decade to 2013-14, real gross state product has grown at an annual rate of almost 5 pc in WA and 3.5 pc in Queensland, compared with 2.5 pc or less in the other states. This has caused NSW’s share of Australian GDP to fall by 4 pc points to 31 pc. Victoria’s share has fallen by 2 pc points to 22 pc, while Queensland’s share has increased by 1 pc point to 19 pc and WA’s share has increased by 6 pc points to 17 pc. SA’s and Tasmania’s shares have fallen a little to 6 pc and 2 pc respectively.

You would expect the states’ population shares to be similar to their shares of the national economy. This is generally true, but with two notable exceptions. Victoria has 25 pc of the population (and of national employment) but only 22 pc of the economy (which may imply that it has a relatively high proportion of low-paid service sector jobs). And WA’s heavy dependence on capital-intensive mining means it has a 17 pc share of the economy, but just 11 pc of the national population.

For the most part, each state’s industrial structure is not very different from the national average, measured by output. But there are some notable divergences. NSW’s greatest strength is in business services, which account for 30 pc of its total output. Victoria’s manufacturing sector accounts for 7 pc of its total output, little different from the national average of 6 pc. Its greatest strength turns out to be, like NSW’s, business services, accounting for 27 pc of its output, compared to an average of 16 pc for the other four states. Queensland’s industrial structure is surprisingly similar to the national average, apart from a larger mining sector. But WA’s mining sector really dominates its economy, accounting for an amazing 30 pc of its output, compared with an average of about 2 pc for the other four states. SA and Tasmania are notable for their well above-average dependence on agriculture.

Good graphs from the Australian Industry Report for 2014

http://www.industry.gov.au/Office-of-the-Chief-Economist/Publications/Pages/Australian-Industry-Report.aspx

Chart 2.11 Output share by sector (1993-94 - 2013-14) report page 91   (PDF page 105)

Chart 2.16 Employment share by sector (1993-94 - 2013-14) report page 97  (PDF page 111)

Chart 2.17 Change in employment (2003-04 to 2013-14) report page 98  (PDF page 112)

Chart 2.23 Employment growth by occupation (2004 - 2014) report page 107  (PDF page 121)

Table A3: Industry Share of State Production

Good tables from RBA Bulletin, March quarter, 2015, article, The Economic Performance of the States

http://www.rba.gov.au/publications/bulletin/2015/mar/pdf/bu-0315-2.pdf

Appendix A

Table A1: Relative Size of States, 2013-14

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Why monetary policy stimulus is less effective

The advent of "stagflation" in the 1970s - the previously unknown combination of high inflation with high unemployment - led to a loss of confidence in Keynesian policies, with primary responsibility for management of the macro economy being shifted to monetary policy and with fiscal policy taking a lesser role.

Four decades later, the wheel may be turning again. The two hot stories in the world of macro management are the decline in effectiveness of monetary policy and a consequent resurgence of interest in active fiscal policy.

Last week Dr Philip Lowe, deputy governor of the Reserve Bank, gave a speech explaining the monetary policy story, so let's look at that today and leave the fiscal story for another day. (Monetary policy refers to the central bank's manipulation of interest rates - and, these days, its creation of money - and fiscal policy refers to the government's manipulation of taxation and government spending in the budget.)

In the aftermath of the global financial crisis of 2008, the big developed countries' central banks cut their official interest rates virtually to zero in their efforts to stimulate demand, avert a depression and get their economies moving again.

When this didn't seem to be having much effect, but being unable to cut their official rates below what economists pompously call "the zero lower bound", first the US and Britain, then Japan, then the euro zone resorted to an unorthodox practice known as "quantitative easing": central banks buying bonds from the commercial banks and paying for them by creating money out of thin air.

The main way this stimulated their economies was by pushing down their exchange rates relative to the currencies of those countries that didn't resort to QE - us, for example.

The Europeans got so desperate to get their economies moving their next step was to do something formerly believed impossible: they cut their official interest rate below zero - meaning the central bank charges its commercial banks a tiny percentage for allowing them to deposit money in their central-bank accounts. In a few cases, the commercial banks have passed on this "negative interest rate" to their business depositors.

As Lowe says, the present global monetary environment is "quite extraordinary". There's been unprecedented money creation by major central banks, official interest rates are negative across much of Europe, long-term government bond yields (interest rates) in most advance countries are the lowest in history and lending rates for many private-sector borrowers are the lowest ever.

Had anything like this much stimulus been applied in earlier decades, economies would be booming and inflation would have taken off. Instead, though the US and British economies are now growing moderately, Japan and the rest of Europe remain mired, with considerable idle capacity. Inflation rates are low almost everywhere and inflation expectations have generally declined, not increased.

But why have things changed so much? Lowe says it's partly because the GFC was the biggest financial shock since the Great Depression and so has required a much bigger dose of monetary stimulus than usual, which is taking longer than usual to work.

But it's also partly because monetary policy is less effective. "Economic activity does not appear to have responded to the stimulatory monetary conditions in the way that occurred in the past and inflation rates have been very low," he says.

The single most important factor causing the change, he says, is the very high levels of debt now existing in many advanced economies.

One of the "channels" through which stimulatory monetary policy works is by the lower interest rates encouraging people to borrow so as to bring forward future spending. This has worked well in the past, but the high stock of debt acquired from past episodes has left many households, businesses and banks (and even in some cases, perversely, governments) unwilling to add to their debt.

Rather, they're using the low interest rates to help "repair their balance sheets" by paying down their debts.

One aspect of easy monetary policy that is still working normally, however, is the rapid rise in the prices of assets such as property and shares.

Another thing that's different is the flow-on from demand to prices. Both workers and firms seem to perceive their pricing power to have been reduced. More worried about keeping their jobs, workers are accepting much lower wage rises. More worried about losing customers, firms are more cautious about putting up their prices.

So how is all this affecting us in Australia? Lowe says one big effect is to leave us with an exchange rate that's higher than it should be; that hasn't fallen as much as the fall in our mineral export prices implies it should have.

This has required the Reserve Bank to cut our official interest rate by more than it thinks ideal. It's done this partly to reduce our interest rates relative to other advanced countries' rates and so put some downward pressure on our dollar, but mainly to make up for the inadequate stimulus coming from the still-too-high exchange rate.

The big drawback to our very low interest rates is the boom in asset prices: for shares and, more worryingly, houses.

Second, Lowe says, the same factors affecting global monetary policy are evident in Oz, although to a lesser extent. Our banks, businesses and governments don't have excessive levels of debt, but our households do. So, many are using the fall in mortgage interest rates to step up their repayments of principal rather than increase their consumer spending.

Retirees living on interest earnings seem to have cut their consumption rather than eat into their capital.

Our wage growth is surprisingly low, contributing to low inflation.

Lowe's conclusion, however, is that our monetary policy is still working. And once the major advanced economies have fully recovered from the Great Recession - which could take as long as another decade - global monetary policy will return to normal.

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Tears for first-home buyers the crocodile kind

Joe Hockey wants to help young people buy their first home by letting them dip into their superannuation, while NSW Labor leader Luke Foley wants to improve affordability by letting them pay off the stamp duty on their purchase over five years. Really? I often wonder whether our politicians are knaves or just fools.

But while we're questioning the sense and morality of our pollies, we shouldn't neglect to ask whether they're just reflecting our own weaknesses. There are few subjects on which more crocodile tears are shed than housing affordability.

At bottom, the economics of housing affordability is dead simple. Sometimes housing can be hard to afford because mortgage interest rates are way too high. But that hasn't been the case since we got inflation back down to normal levels in the mid-1990s.

And at present just the reverse applies. Mortgage interest rates are abnormally low. They won't stay that way, of course.

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So if interest rates aren't the problem, the other factor is home prices. In a market economy like ours, the price of anything – whether ordinary goods or services, or an asset such as a house – rises when the demand for it exceeds its supply.

For some years now, the supply of additional houses and units has failed to grow in line with "household formation" – young people getting married, people immigrating to Australia and couples splitting up.

So inadequate growth in supply has been the real problem, caused by state and local governments placing too many legal obstacles and charges in the path of developers seeking to build new estates on the edge of the city and – perhaps more important – seeking to provide medium- and high-density "infill" closer in, where people increasingly prefer to live to avoid long commutes.

The NSW Coalition government claims to have made progress in reducing these obstacles, and it's true that housing construction is growing faster in Sydney at present than it has been.

But though the basic problem has been maintaining an adequate supply of appropriately located housing to meet the growing demand, the supply side of the problem isn't terribly visible to you and me.

We're more conscious of the demand side, represented by the high and ever-rising cost of buying a place faced by our kids and other young people. What's more, we suffer from a kind of optical illusion. Your daughter and her partner are just sitting there saving, watching some invisible force push house prices further and further out of their reach.

The trick is that while no single purchaser can move the market price, the combined demand of all purchasers can – and does, as we watch.

Our natural, uneducated tendency to see the house price problem from the viewpoint of the individual buyer makes us susceptible to the pseudo solutions peddled by politicians seeking votes.

If only my daughter could get a bit of a leg-up in either putting together a sufficient deposit (say, by being allowed to dip into super) or in lowering the initial cost of the purchase (say, by staggering the cost of stamp duty), she could afford to take on the mortgage and she'd be right.

See the weakness in that logic? If it helps your daughter and her partner, it also helps all the couples they're competing against to buy a place. Which means it gets your daughter nowhere. Actually, she's worse off. Since everyone can now more easily afford to pay the existing price, the prices of the homes they want to buy go even higher.

As economists say, the benefit from the caring pollie's supposed helping hand is "capitalised" into the price of "ideal first homes". And that means the benefit of the measure ends up going not to first-home buyers but to first-home sellers.

Economists have understood this perverse outcome since the year dot. Their rule is simple: when demand for housing is running ahead of supply, anything you do to make it easier for people to afford the high prices ends up only making prices higher, to the cost of buyers and the benefit of existing home owners.

It's possible Hockey and Foley aren't sufficiently economically literate to have worked out that their proposals would be counterproductive. (Not to mention that Hockey's would leave young people's eventual retirement payouts significantly diminished because of their loss of compound interest, or that Foley's would leave fully financially committed couples with additional large lump-sum payments for five years.)

What's not credible is that these guys' economic advisers would have failed to warn them of the perverse consequences of their proposals. So they may just be fools, but my practice is to give their intelligence or competence the benefit of the doubt and assume they're knaves: they knew it was a con, but were confident most voters wouldn't see through it, so they proposed it anyway.

And remember this: in any year, the number of voting home owners far exceeds the number of would-be home owners. So how could proposing a scheme that pretended to help first-home buyers while actually helping existing home owners cost you more votes than it gained?

The pollies know that proposing phoney schemes to help young home buyers without actually lowering the value of the homes owned by the rest of us is exactly the kind of help we prefer them to offer.

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Econocrats doubt our ability to grow

So, how fast can we expect the economy to grow over the next 40 years? And, more to the point, where's that growth supposed to come from? That's a doubt you expect from people without the benefit of an economics education, but the intergenerational report reveals the econocrats are going through a crisis of confidence about growth.

First, a disclaimer: not being as materialist as the economists, I don't see maximising our material standard of living as the ultimate objective. I worry more about what climate change and resource depletion will have done to the economy in 40 years' time, and the social price we'll be paying for our obsession with the material.

But back to the dominant paradigm.

The report projects that growth in real gross domestic product will slow to an average rate of 2.8 per cent a year over the next 40 years, down from 3.1 per cent a year over the past 40.

A third of this decline is explained by slightly slower population growth, leaving average growth in real GDP per person falling from 1.7 per cent a year in the past to 1.5 per cent a year in the future.

I trust you're suitably shocked and dismayed. This projected decline is explained essentially by the ageing of the population, leaving the average rate of improvement in the productivity of labour unchanged between the past and the future at 1.5 per cent a year.

So, where will the growth be coming from? Exclusively from improving productivity: from the economy's output of goods and services growing faster than its inputs of labour.

It's productivity the econocrats and other economists are so pessimistic about. So how did they estimate that productivity will grow by an average of just 1.5 per cent a year?

They didn't. They simply followed previous practice and plugged in the same figure for the coming 40 years as for the past 30. Since it's impossible to know what will happen to productivity in the future, this neutral assumption is better than any other you could make.

But that hasn't stopped some economists from claiming that 1.5 per cent a year is overly optimistic. Really? This tells you something about the reigning mood of pessimism among economists.

But if income per person is driven by productivity improvement, what drives productivity? If you rely on the things economists say in public, you could be forgiven for not knowing that overwhelmingly – and for the past 200 years – it's technological advance.

Every economist knows that's true but they rarely say so. That's partly because they know little about how technological advance works and partly because they believe there's little they can do to affect it.

But in recent years, some leading overseas economists have lost their faith that rapid technological advance will continue lifting material living standards. Two centuries of innovation have hit a dry spot, we're told.

It seems Treasury agrees. It admits a fact rarely included in economists' unceasing sermons on the evil of our low rate of productivity improvement in recent times: "Australia has not been alone among advanced economies in experiencing slower productivity growth over the 2000s, which suggests that the rate of growth in technological advance . . . may have been slower than in previous decades."

So if we can't rely on a continuing stream of new technology to keep our living standards growing at a rate economists find acceptable, what does Treasury suggest? It was hoping you'd ask because it's got just the solution we need: more microeconomic or "structural" reform.

For several years, all right-thinking economists have been badgering us to pressure governments for more micro reform. To bolster its argument that micro reform is the missing elixir, Treasury says "the increase in productivity growth rates seen in the 1990s is widely attributed to significant policy reforms of that decade and the 1980s".

But even if you believe this (I'm sceptical), it's hardly a great advertisement for the benefits of reform. You can make the most sweeping reforms – reforms which, having been made, can't be repeated – and all you get for your pains is four or five years of improved performance before lapsing back into mediocrity.

Reform, we're asked to believe, is only a fleeting fix. To maintain an acceptable rate of productivity improvement, reform must be unceasing (and defy the law of diminishing returns).

This portrays our economy as hopelessly inefficient and unproductive, despite all our efforts. Other countries can grow satisfactorily without continuous reform, but we can't.

Really? Such a view is so deeply pessimistic as to verge on economic apostasy. It's also bizarre.

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More infrastructure spending would boost economy

It's good to see Joe Hockey finally making the transition to government and joining the economic optimists' party. This week he greeted the national accounts by saying the economy had grown by "a solid 0.5 per cent in the December quarter to be 2.5 per cent higher over the past year".

"Our income as a nation picked up in the quarter, with nominal gross domestic product rising by a solid 0.6 per cent," he continued. "Real gross national income also rose in the quarter."

A treasurer should never talk the economy down, just as the official forecasters should never be the first to predict imminent recession. Such negativity tends to be self-fulfilling.

So I'm sorry to rain on Hockey's parade by telling you that "solid" growth is the econocrats' euphemism for "not so hot".

Just so. Annual growth of 2.5 per cent is well below our trend (average) rate of 3 per cent, especially disappointing when you remember we've been well below trend for quite a few years.

But though the figures from the Bureau of Statistics were unsatisfactory, they don't support the earlier fears of some that the economy fell apart in the previous quarter. A sensible reading is that the economy continues to plug along at the rate of about 2.5 per cent a year.

This, of course, is insufficient to stop unemployment rising. But for some years the rate of worsening has been steady at about 0.1 percentage points a quarter – which fits with reasonably steady growth in real GDP of about 2.5 per cent a year.

One encouraging sign in the accounts is that consumer spending grew by 0.9 per cent in the quarter and 2.8 per cent over the year. This isn't too bad when you consider that, with weak growth in employment and wages, real household income is growing at an annual rate of only about 1 per cent, according to calculations by Kieran Davies of Barclays bank.

Clearly, households must be reducing their rate of saving. Over the past year it's edged down by about 1 percentage point to a still-high 9 per cent of household disposable income. From now on consumer spending should be boosted by the fall in petrol prices.

Another bright spot is home building, which grew by 2.5 per cent in the quarter and by more than 8 per cent over the year. This is one area where the Reserve Bank's exceptionally low interest rates are really working, with building approvals reaching an all-time high in January.

It's likely all the real estate activity is helping to boost consumer spending on durables. There's nothing like changing houses to make you think you need a new lounge suite.

The weakest part of the accounts was business investment spending, which fell by almost 1 per cent in the quarter. Within this, and according to Davies' figuring, mining investment fell by 5 per cent while non-mining investment grew by only 2 per cent.

This is where we need the economy to be making the transition from the mining investment boom to non-mining-led growth. It's happening, but not fast enough to get the economy heading back towards trend growth.

That's why the Reserve has reverted to cutting interest rates. Not so much because the economy was slowing as because it wasn't picking up the way it had expected. And it's early days yet: mining investment fell by about 13 per cent last year, it's expected to fall by about that much again this year and by a lesser amount in 2016.

Arithmetically, the big saviour was the rising volume of exports, up 1 per cent in the quarter and more than 7 per cent over the year. This was driven by mineral exports, of course.

Combine that with a 2.5 per cent fall in the volume of imports in the quarter and "net exports" (exports minus imports) contributed 0.7 percentage points to GDP growth in the quarter and 2 percentage points to growth over the year.

Why are imports falling? Mainly because less mining investment means fewer imports of heavy mining equipment, but also because the fall in the dollar seems to have discouraged imports of business services and Aussies from "importing" overseas holidays.

But I can't get too excited about the surge in mineral exports. Mining is so capital-intensive that far fewer jobs are created by higher mineral exports than you'd expect from a jump in other exports. If that's the best we've got going for us, it's not good enough.

One more point of interest: spending by the public sector rose by a mere 0.1 per cent in the quarter and actually fell by 1.1 per cent over year. So, no help from government spending in getting the economy moving.

But before you start muttering about "austerity" and blaming poor old Joe, note this: public consumption spending rose by 0.4 per cent in the quarter and by 2 per cent over the year, whereas public investment spending fell by 0.9 per cent in the quarter and by (an amazing) 11.9 per cent over the year.

The great bulk of spending on capital works – "infrastructure" if you prefer – is done by the state governments. So it seems that, between them, the state governments – unduly worried about retaining their high credit ratings – have been allowing their works programs to run down.

This at a time when so many mining construction projects are winding up and construction workers and other resources are becoming available. Sensible governments adjust their construction programs to fit with downturns in private sector activity and take advantage of lower construction costs, thereby doing themselves and the economy a favour.

With monetary policy (interest rates) now less effective in stimulating the economy, it would be better if fiscal policy (budgets) was doing more to help, not less.

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Intergenerational report a disappointment

The five-yearly intergenerational report ought to be highly informative, leading to serious debate about the economic choices we face. In the hands of Joe Hockey, however, it has become little more than a crude propaganda exercise.

As such it will be quickly cast aside, like last year's report of the Commission of Audit. Within a few days all that will remain is the taxpayer-funded advertising campaign. It, too, will be more about spin than brain-food.

Hockey has shifted the report's focus from the next 40 years to the government's present struggles with the budget. The message he wants us to take away is that it's all Labor fault, but the government has worked hard to greatly reduce the problem. And were not for those crazies in the Senate - who seem to think our spending cuts were unfair - last year's budget would have set us up for budget surpluses right through to 2055.

The message we should take away from it, as with its three predecessors, is one no politician on either side is prepared to admit: as our demands on the government for more and better services continue to grow, we will have pay for them with higher taxes. Since our real incomes are projected to rise by almost 80 per cent, this won't be so terrible.

Instead, the message from all these reports is that there is no alternative to sweeping cuts in government spending, unfair or not.

They come to this conclusion by quietly assuming that before long we will return to annual tax cuts, even as the budget deficit and debt get bigger every year. Sure.

If you wonder how anyone could have any idea of how things will play out over the next 40 years, you are right. No one can. The one thing we can be sure of is that, whatever the budget and the economy end up looking like in 2055, it won't be what this report says they will.

The mechanical projections in this report are based on a host of assumptions about an unknowable future. Some of those assumptions are spelt out in the fine print, some aren't. Some are honest guesses, some have been chosen to lead us to the conclusions the government wants us to reach.

One demonstration that projecting what will happen over the next 40 years is unavoidably dodgy is that the four successive reports have each come up with widely differing figures for where the budget will end up.

One demonstration of the report's lack of genuine concern about our future is its dismissive treatment of climate change. The biggest risk we face in 40 years' time is the budget deficit?

One demonstration of the report's inadequacy is its failure to take account of what may be happening to the state governments' budgets. This allows it to claim last year's budget measures would have restored the feds to eternal surplus, while ignore the consequences of Hockey's proposal for ever-growing cuts in grants to the states for hospitals and schools. Really?

To be fair, before Hockey got into the act Treasury would use the intergenerational report for its own propaganda. Its message was aimed at its political masters: the budget may look OK now, but there is a lot extra spending coming in a few years' time, so keep running a tight ship.

It was spectacularly unsuccessful. The Howard government went mad with tax cuts and middle-class welfare and Rudd and Gillard were a fraction worse with their unfunded schemes to help disadvantaged school kids and the disabled.

And these guys think it's all our fault?

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Cities: jobs in the centre, most people on the outer

It's remarkable how few new ideas most economists get. They look at the world the way they always have and worry about the same things they've always worried about, chasing the same rabbits down the same burrows.

They analyse the world using their standard model and see those things the model is designed to highlight, but don't see anything that's outside its scope.

What most economists rarely think about is the spatial dimension of the economy. It's ignored by their model, so it's ignored by them. Could it have something to tell us about why the economy isn't functioning as well as it could? Who knows?

Jane-Frances Kelly and Paul Donegan, that's who. They've been studying the economics of our cities for the Grattan Institute, and their eye-opening findings are explained in their new book, City Limits: Why Australia's cities are broken and how we can fix them. Here's my version of their message.

Despite our self-image as sun-bronzed sons and daughters of the soil, we are a nation of city-dwellers. Australia is one of the most urbanised countries in the world.

Our capital cities are growing and most of our income is being generated in them, notwithstanding the big expansion in mining, which is more about additional structures and capital equipment than workers.

For at least the past 40 years, all the net increase in employment has been in the services sector, and the services sector exists mainly in cities. The arrival of the knowledge economy will only heighten this trend.

Most of the economic action in our capitals is occurring near the centre of the city. Just the Sydney and Melbourne central business districts – occupying a combined area of a mere 10 square kilometres - account for about a quarter of each city's production.

Businesses crowd into the CBD because it gives them the easiest access to desirable employees and because they benefit from being close to the other firms in their industry and their suppliers. It facilitates the transfer of knowledge. Get it? They think that crowding together increases their productivity.

The biggest trend in city property prices is not just big rises over time, but the way inner-city prices are rising so much faster than outer-city prices as people seek "proximity" – closeness to the centre, with all its facilities and jobs.

Researchers at the Reserve Bank have shown that if you draw a graph with home prices on the vertical axis and distance from the CBD on the horizontal axis and then plot actual prices, you get an almost perfectly downward-sloping curve for Sydney, Melbourne, Perth or Brisbane. On average, prices are highest close in and lowest far out.

For the five mainland state capitals, 60 per cent of all the employment growth over the five years to 2011 occurred within 10 kilometres of the centre. But here's the problem: no doubt because inner-city house prices were so high, about 55 per cent of the population growth occurred 20 kilometres or more from the centre.

In other words, we've been developing a big economic and social problem few economists have noticed: a growing spatial divide between where the jobs are and where people live.

It's an economic problem because it increases the economy-wide costs of each day's production of goods and services. It's a social problem because, for the most part, those costs fall on the less-wealthy working families living in outer suburbs. Some of the costs come as dollars paid, some as time wasted and some as opportunities forgone.

The growing distance between where we live and where we work means car travel in peak periods is getting slower in all capital cities. Traffic is slowest on inner-suburban roads, because that's where most people are travelling to or from.

Over the past decade, the proportion of people spending more than 10 hours a week commuting has increased by about half. One in four full-time employees spends more time commuting than with their children.

Women caring for children in outer suburbs face tough choices, with a lack of accessible jobs forcing some out of the workforce altogether.

So what can we do about it? We need to reduce congestion and make it easier, quicker and cheaper to move across the city. To me that means improving access to public transport – which is excellent in the inner-city and woeful in the outer suburbs – not returning to our earlier delusion that building more expressways will fix it.

One day we'll have the courage to use time-of-use tolling to encourage those who have the flexibility to avoid travelling in peak periods to stop doing so.

But improving public transport is expensive and can be only part of the solution. The authors stress the need to increase the supply of semi-detached homes – terraces, townhouses and low-rise blocks of flats – in inner and middle suburbs.

This would require changes to complex planning and zoning regulations – and a lot of public consultation if the changes are to stick. But if so many people want to live closer in, we need to accommodate their wishes.

With the release of another intergenerational report this week, we'll be hearing much agonising by politicians and economists about why our productive efficiency isn't improving fast enough. But don't hold your breath waiting for them to acknowledge that a fair part of their problem is spatial.

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Treasury under new management

How much does the Treasury's view of the world change when a prime minister comes to power, sacks the head of Treasury (and his heir apparent) and replaces him with his own hand-picked man from outside the public service?

That's what the economic cognoscenti were asking last week when our first political appointment as Treasury secretary, John Fraser, made his first public appearances at a Senate estimates hearing and as a speaker at a conference of the Committee for Economic Development of Australia.

Fraser had risen to the rank of deputy secretary when he left Treasury in 1993 to make his name and fortune as an investment banker at the global level of the UBS bank. It's hard to imagine such an old and rich chap would hang around long if he found his advice wasn't being heeded.

From what he's said so far, you don't get the feeling Fraser has spent the past 22 years keeping tabs on the Australian economy or keeping abreast of the latest applied research on fiscal policy. Even so, he's a man of strong and confidently held opinions, who isn't afraid to tell you about them.

His views were pretty conservative when he left Treasury, at a time when the views of Treasury itself were more cautious than they've been in recent years, and his time as a chief executive is unlikely to have radicalised him.

Dr Martin Parkinson and Dr Blair Comley seem to have been sacked for their lack of scepticism about climate change, so we can presume Fraser doesn't share that failing. I may be wrong, but I don't see him as someone who wastes much time worrying about "wellbeing frameworks".

We know from his evidence to the Senate that he's a great admirer of Ronald Reagan's tax cuts of the early 1980s (which did so much to lay the foundations for America's present towering public debt), but has "old-fashioned" views about the evil of public debt.

He is sceptical about using the budget to stimulate the economy when it's very weak – which means he's invalidated one of the best arguments for getting debt down: the need to "reload the fiscal cannon" ready for the next recession.

And he thinks the policy of "austerity" practised in Britain and (by default) America has been a great success. This opinion he expressed to the Senate and backed up with figures in his later speech.

To silly people on the left, "austerity" is a swear word you slap on any budget saving you disagree with. But it really means a policy of cutting the budget deficit hard even while the economy is very weak.

The lefties never understood that Joe Hockey's first budget was carefully crafted to involve minimal net cuts to the deficit in the first three years, with the big hit delayed until 2017, when the economy was expected to be back growing strongly.

So, is true austerity about to come to Oz under the advice of the new Treasury boss? You might think so. Fraser says "we need to start now" and repairing the fiscal (budgetary) position is "an immediate priority".

But I'm not so sure. Later in his speech he advocates "committing now to savings measures that build over time to deliver a return to surplus over the medium term". And asked if now was the time to cut savagely considering the weak outlook, he said the coming budget would have to be "tailored to the situation".

While much of what Fraser has said so far is what you'd expect of an Abbott appointee, some of it isn't. His summary of how the budget got into its present state doesn't put all the blame on Labor, but acknowledges the role of excessive tax cuts and spending by the Howard government.

And while noting that government spending has grown at an average real rate of more than 4 per cent a year since 2007-08 (mainly under Labor), he also noted that it grew by about 3.5 per cent a year over the four years to 2007-08 under the sainted Howard government.

He is sharply critical of the increase in "middle-class welfare" in Howard's last years, including Peter Costello's (obviously unsustainable) superannuation changes, which he highlights for reform.

And unlike the huge majority of economists, he frankly admits the great drawback to using immigration to boost economic growth: it "places additional demands on government budgets in areas such as infrastructure, health and education".

Maybe high immigration, but inadequate investment in business equipment, housing and public infrastructure, help explain why our rate of productivity improvement isn't as great as Fraser says we need.

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