ECONOMIC MODELING FOR JUDGES

Talk to Federal Court judges’ continuing education day, Brisbane, March 19, 2015

It’s normal for economists in my position to give you a happy chat about the state of the economy - or the world economy - full of forecasts about how things will turn out and warnings about what the economic managers need to do to ensure everything turns out well. But we all know many of my predictions would turn out to be wrong, and those that were right would probably be right for reasons I hadn’t foreseen. It’s one of the great mysteries of modern life that economists can be so bad at forecasting without the public ever tiring of asking them for more.

But such talks are usually accompanied by a PowerPoint presentation with copious graphs, and I’ve never got the hang of PowerPoint. In any case, though I have three years of economics in my commerce degree, I don’t regard myself as an economist, but rather as a journalist who writes about economics. I’m not a member of the economists’ union. This allows me to act as a kind of interpreter and go-between, standing between the economists and the public. I see my role as providing my readers with a critique of economics and economists, much as our theatre critics provide our readers with a critique of the latest plays. My goal is to explain and demystify economics, advising my readers on when they ought to accept the advice of economists and when they shouldn’t.

So today I want to talk about economics and economists, with special reference to that mystifying animal, economic modelling. The world is full of experts but, particularly in the area of public policy, few experts’ advice gets taken as seriously as economists’ advice. I imagine the economic aspects of the matters that come before you aren’t often kept in the background; that you often have people mounting economic arguments - or arguments that seem economic to the unqualified mind - and that some of you even have economists appearing before you as expert witnesses.

I find it interesting to speculate about why economics and the advice of economists get taken so much more seriously these days than they were in years past. My theory is that it’s because we live in an age of heightened materialism. There’s nothing new about materialism, of course, we’re all materialistic to a greater or lesser extent, and those who never spare a thought for the material aspect of their lives will be lucky if they don’t starve. But I think we’ve become more materialistic than we were - you can see that in the way the aspirations of entrants to American colleges have changed over the years - and this leaves us as a community more inclined to listen to and act on the advice of economists. But, I suspect, it’s a two-process: the more we listen to economists, the more materialist our attitudes become. So, if I’m right, the dominance of economic advice is both an effect and a cause of our era of heightened materialism.

Economics is the study of how market economies organise the production and consumption of goods and services. In other words, it deals with a very important aspect of life - all of us are consumers and most of us are producers - but only one aspect. It’s preoccupied with the practical, material aspect of life.

But there are lots of ways to define economics and another way is to say it’s the study of ‘the economic problem’, which is the problem of scarcity. Scarcity arises because our resources - of land, labour and capital - are finite, whereas our wants are infinite. Scarcity in this context doesn’t mean as scarce as hen’s teeth, just that things aren’t free - they can be acquired only at a price. So economists advise the community on ways to use our finite resources to satisfy as many of our wants as possible. This explains economists’ preoccupation with efficiency: the more efficiently we use our resources, the more wants we can satisfy, the more bang we can get for our buck.

The conventional economist’s first piece of advice to the community is that the most efficient - or least inefficient - way for a community to organise production and consumption is via markets. Governments will need to ‘hold the ring’ in a market economy, conferring and enforcing private property rights, enforcing the law of contract, providing bankruptcy laws, providing companies with limited liability, imposing adequate standards of financial reporting and auditing, and the like. There will be other instances of significant ‘market failure’ but, for the most part, most conventional economists believe that government regulation of markets, or intervention in markets, should be kept as limited as possible so the ‘invisible hand’ of market forces can play its semi-miraculous role of causing all things to work together for good.

If that sounds sarcastic, it’s not intended to be. There are two mistakes you can make about market forces: to underestimate their power or to conclude they’re near infallible. I’m about to bring to your attention the limitations and weaknesses of conventional economics and economists and their advice, but I’d hate to leave you with the impression I regard economics as little more than a hoax. I certainly don’t. The world would be much poorer without the contribution of economists and their discipline. They may not be much chop at forecasting, but that doesn’t mean they don’t know more about the workings of markets and the macro economy than the rest of us. If had more time I’d be happy to give you a list of their most valuable insights, but I think it’s more important for you to understand their limitations.

I want to make five points about economics and the economists’ art, before making five points about economic modelling.

The first point about economics is that it’s narrower than many people realise. We assume that economists are experts on the economy, but it’s truer to say they’re experts on the markets that help to make up the economy. Their basic model - known as the neo-classical model - is a model of how markets work through the interaction of supply on the one hand and demand on the other. This interaction determines the price of the good or service in question and it’s the market price that that brings demand and supply into balance (‘equilibrium’). This means that economists are obsessed by prices. If economists wore tee-shirts they’d say: Prices make the world go round. Economists believe the key to the efficient allocation of resources - to making our finite resources satisfy as many of our infinite wants as possible - is to get the price right which, for the most part, you do by leaving market forces free to determine that price.

Second, like all professions, economists suffer from what I call ‘model blindness’.  Just like model trains or model planes, economic models consciously simplify complex reality. They’d be of no use if they didn’t. The idea is to include and highlight the key factors and get rid of the unimportant issues that merely cloud the workings, thereby capturing the essence of what causes what. The neo-classical model strips away other commercial considerations so it can get to what economists regard as the heart of the matter, price. The question to ask of a model is not whether it’s left things out, but whether what it’s left out is important. And the test of that is how good it is at predicting how people (‘economic agents’) will behave in given circumstances. I believe that, in many circumstances, the standard model’s prediction record is poor. That is, it leaves out a lot of factors that do turn out to be important.

To put it another way, the motivations for human behaviour are simply too complex to be adequate captured by any model. It’s fashionable to say that economics is ‘the study of incentives’, but that’s just a sexy way of saying economics is the study of prices. To an economist, prices and the changes in them are the one great incentive - to produce more or buy less, or to produce less or buy more, depending on whether the price has risen or fallen and on whether you’re a producer or a consumer. One major limitation of economic analysis is that it can’t take account of any factor that can’t be not just quantified, but also valued in dollars. Sometimes when a relevant factor doesn’t have a market price because it’s not traded in a market, economists will try to estimate a ‘shadow’ price for it but, for the most part, factors than can’t be monetised are simply ignored. So economists end up tacitly assuming people are motivated solely by monetary considerations. No one does anything out of the goodness of their heart, because of a sense of duty, because they simply enjoy doing a good job or because they’re seeking power and influence. Little wonder economists aren’t much good at predicting people’s behaviour.

The economists’ model has many other limitations but, as with all professions, economists tend to lose sight of the factors that have been excluded from their model. Just as lawyers tend to view every problem from a legal perspective and doctors see all problems as medical, so economists suffer from their own ‘model blindness’ - a tendency to view the world and to analyse problems exclusively through the prism of their model; to focus on those variables their model focuses on and to ignore all those factors from which their model abstracts.

It’s the job of their hearers - including judges - to quiz them about which factors they haven’t taken into account and what their relevance might be. On that score, it’s important to be aware that most economic estimates of the extra income (economic growth) that this or that action would bring about take no account of the ‘distribution’ of that extra income between high, middle and low-income families. In other words, one of the factors from which the model abstracts is questions of fairness. Although a few economists specialise in studying distributional questions, most economists’ analyses ignore it. When pressed, they’ll tell you perceptions of fairness are subjective and so outside their field of competence. So they leave them for others to judge - politicians, for instance. Their specialty is efficiency, not ‘equity’. Trouble is, if you don’t press them they probably won’t mention this limitation to their advice. By contrast, the public tends to regard questions of fairness - who wins, who loses - as highly relevant to the decision-making process.

Third, though it’s fashionable to bang on about the need for decisions to be evidence based, economics is more faith-based than evidence-based. Actually it’s better to say economic analysis is theory-based, with only a secondary appeal to empirical evidence. Whereas the hard sciences collect empirical evidence then try to think of theories that best explain that evidence, economics works the other way. It starts with theories (models) based on assumptions - assumptions which, in the basic neo-classical model, have changed little since the second half of the 19th century - then looks for empirical evidence that supports the theory.

This is not to imply there’s been little advance in the economics profession’s thinking since the 19th century. There has been. Most of the Nobel prizes in economics awarded in recent decades have gone to economists exploring the limitations of the basic model’s assumptions - advances such as information economics and behavioural economics. But most of these advances have been too hard to express mathematically, or too hard to measure, for them to have made much impact on either ‘the economic way of thinking’ or the formal mathematical models used to make forecasts about the economy or about the effects of a particular policy change.

One important but only implicit assumption built into economists’ thinking and their formal models is that the parties to a transaction - say, Woolworths and one of its suppliers, Coles and one of its customers, or any employer and one of its workers - are of roughly equal bargaining power. The inappropriateness of such an assumption does much to explain the government intervention embodied in many of the acts you deal with, including the Competition and Consumer Act.

Fourth, economists and, more particularly, economic rationalists, tend to be missionary or imperialistic in their attitudes. Notwithstanding the narrowness of their model - its focus on the material dimension of our lives and abstraction from the relational, social, cultural and spiritual dimensions; its abstraction from considerations of fairness and significantly unequal bargaining power - economists of a more fundamentalist disposition want us to think like economists think and make economic growth and efficiency in the allocation of resources our overwhelming priority.

Significant parts of our community life have not been part of any market. We don’t allow people to buy and sell blood or body parts, for instance, much of our sport is amateur, many speeches are still given for no recompense other than a bottle of wine and there is much volunteering. But many economic rationalists are so convinced of the benefits of increasing efficiency, and so enamoured of markets as a way of allocating resources efficiently, that they want to see more and more aspects of our lives given over to the market. They want to commercialise and privatise government-owned businesses, and contract out the provision of government services such as job search assistance and childcare. They want to raise more revenue from user charges and less from general taxation. The de facto privatisation of our universities has been proceeding for several decades. Rationalists want to complete the commercialisation of the weekend by completing the deregulation of shopping hours and removing penalty rates. What effect would this have on family life? It’s literally of no consideration; it’s not in the model.

Economic advice is often so missionary, while being so one-dimensional, that it ought to come with a product warning: here’s a list of all the factors I haven’t taken into account in proffering you this advice; you should probably consult a social psychologist or sociologist or cleric before acting on my recommendations. But it rarely comes with any qualification: I’m an expert and here’s what you should do.

Finally, economists have no professional association - no law society or bar council - and so have no expressed or enforced standards of ethical behaviour. The Economic Society is essentially a discussion group that the unqualified are welcome to join. So these days the many firms of economic consultants or the economists undertaking similar work for the big accounting firms, such as KPMG and Deloitte, are under no external ethical constraint when they provide supposedly independent economic advice to paying customers advocating or opposing government policies, or when they appear as expert witnesses.

Which brings us neatly to economic modelling exercises. I make no profession of a deep understanding econometrics, but I’ve quizzed modellers about their models for so long that their limitations are clear enough to me to allow me to make five points.

First, economic models are highly sophisticated and quite primitive at the same time. They’re sophisticated in that they’re a mathematical representation of the linkages between selected elements of the economy. The links are represented by a large number of algebraic equations with numerous variables. The modeller decides the values of the independent (or ‘exogenous’) variables and the model calculates the values of the dependent (‘endogenous’) variables. So if the modeller slots in the wrong independent variables - they’ll usually be assumptions (guesses) about the future - the dependent variables will be wrong, too.

Models are primitive because they’re a hugely oversimplified version of the economy, which often can’t adequately represent the subtleties of the policy changes whose effects they’re purporting to estimate. This lack of subtlety, or a lack of empirical data, means they often make extensive use of ‘proxy’ indicators, a euphemism for ‘the nearest we could find’.

Second, like economic theory itself, economic models are built on a host of assumptions. Indeed, many of those assumptions come from the modeller’s preferred theory about how the economy works. It’s common for ‘computable general equilibrium’ models to have Keynesian assumptions in the short run (up to 10 years) but neo-classical assumptions in the long run (20 years or more). That is, key variables such as inflation, unemployment and economic growth are determined by the strength of aggregate (total) demand in the short run, but by the strength of aggregate supply in the long run.

This means the economy is assumed to be at full employment in the long run, and economic growth over the period is assumed to be determined solely by the growth in the labour force and the rate of improvement in the productivity of labour. Both of those are independent variables, plugged in by the modeller on the basis of some assumption.

So the results you get from such models are largely predetermined by the assumed structure of the economy and the chosen values of the independent variables. Worse, it would be an incompetent modeller who couldn’t tweak the assumptions to ensure the results they got were consistent with what their paying customer was hoping for.

Third, most commercial modellers keep the workings of their models largely hidden. They’ll have some impenetrable qualifications and explanations up the back of their report, but they don’t go out of their way to warn lay users about their model’s assumptions and limitations. Even university economics courses don’t labour the limitations of the theoretical model, and practitioners become so familiar with the way their econometric models work that they can forget about their limitations until they’re challenged. Then, when the results of the modelling are being quoted by the interest group that paid for it - or by politicians on the same side - any remaining restraint is lost and the results are invested with about the same authority and certainty as the Ten Commandments.

Fourth, disinterested parties to whom modelling results are presented should arm themselves with caution and scepticism. All modelling results are rough estimates. Estimates that are expressed too precisely exhibit ‘spurious accuracy’ and are a sign the modeller may be more interest in impressing the punters than enlightening them. Modellers should be asked to outline the key assumptions that are driving the models results and then asked for ‘sensitivity analysis’ of the key variables. That is, if this variable was increased or decreased by 1 percentage point, what difference would it make to the results? Don’t assume that if one economist says an effect is big and another says it’s small, the truth is probably somewhere in the middle.

Finally, be particularly wary of claims about jobs. Businesses are motivated by profits, not a desire to provide employment to people. Economists are on about achieving faster growth in GDP and GDP per person - a crude measure of our improving material standard of living. They know that where there’s growth in GDP there’ll also be growth in employment, but increasing employment is not their primary concern.

But both business people and economists know that when you’re trying to persuade the community to let you undertake a project that will cause economic disruption and environmental damage, there’s just one, killer argument: all the jobs you’ll create. The public have it deeply ingrained in their brain that there’s a permanent excess of unemployed workers and an eternal shortage of jobs, so that you can never have enough jobs. So promise lots of jobs and no further questions will be asked.

This presents businesses and their modellers with an enormous temptation to exaggerate estimates of the number of jobs the project will ‘create’. They’ll focus on the many jobs created in the construction phase, not the much smaller number of permanent jobs. They’ll misuse the multipliers in the Bureau of Statistics’ ‘input-output tables’ to exaggerate the number of jobs to be created ‘indirectly’ in other industries. They’ll forget to remind you that if the jobs to be created are skilled jobs, skilled workers are usually in short supply, so that the jobs won’t be filled by the unemployed but already-employed workers will have to be paid sufficiently highly to attract them away from other employers or from overseas. They won’t mention that if the economy’s growing at a full-employment rate (these days judged by the econocrats to be an unemployment rate of about 5 per cent), it’s just not possible to ‘create’ any additional jobs, merely to move existing jobs from one location to another. Disinterested economists never cease to be amazed by some of the claims made about how many jobs will be created - or, with other lobbying propositions, lost.

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Our kids need social skills, not just high marks

My father raised me to be contemptuous of fashion in all its forms, and I try not to be overawed by the rich and powerful. But, like my mum, there's one thing I am impressed by: brains.

My job brings me into regular contact with the econocrats at the top of the Reserve Bank, Treasury and other departments. Let me tell you, they're the brightest of the bright. I have to keep telling myself this as I struggle to keep up with them. All of them could hold down jobs as professors, or earn a lot more money in business.

These days, most have PhDs - though it's disturbing that, so far in his time as Prime Minister, Tony Abbott has relinquished the services of five economist department secretaries: Dr Martin Parkinson, Dr Don Russell, Blair Comley, Dr Ian Watt and now Dr Paul Grimes. Not sure we have that many brains to spare.

In recent years, however, I've realised that being super-bright ain't enough. To be really successful you also need "people skills". I've decided an extra unit of EQ - emotional intelligence - is worth a lot more than an extra unit of IQ. And if a genie appears from a bottle, that's what I'll ask for.

Most of our politicians have heard that the development of children's brains is hugely significant in influencing their success throughout the rest of their lives. Hence governments' increasing attention to early childhood education and care.

What people may not realise is that brain development doesn't matter just because of its effect on kids' intellect. As a new report from the Organisation for Economic Co-operation and Development, The Power of Social and Emotional Skills, makes clear, it matters also for children's social development.

We don't need telling about the importance of "cognitive" skills. These days, governments conduct periodic tests of children's literacy, numeracy and scientific literacy as they progress through the school system.

They make the results available directly to parents, but also put them on websites so the whole world can compare the academic performance of particular schools. Teachers object that good teaching involves a lot more than the three Rs and that the emphasis on competition via "metrics" encourages schools to "teach to the test" and spend much time drilling for coming tests.

The OECD's PISA exercise now compares our cognitive tests with those undertaken in other countries, so that every year or so we agonise because we've slipped back in the international comp on this cognitive measure or that.

The point of this latest report is to agree with the teachers: there is a lot more to the adequate development of our kids than just nurturing their IQs. It finds that children and adolescents need a balanced set of cognitive and social and emotional skills in order to succeed in modern life.

Cognitive skills - as measured by achievement tests and academic grades - have been show to influence the likelihood of individuals' success in education and the jobs market. They also predict broader outcomes such as our self-perceived health, social and political participation, and trust.

But social and emotional skills - such as perseverance, sociability and self-esteem - have been shown to influence numerous measures of social outcomes, including better health, improved subjective wellbeing (aka happiness) and reduced odds of antisocial behaviour.

If that doesn't impress you, try this: cognitive skills and social and emotional skills interact and cross-fertilise each other, empowering children to succeed both in school and out of school.

For instance, social and emotional skills may help children translate intentions into actions, and thereby improve their likelihood of graduating from university, sticking to healthy lifestyles and avoiding aggressive behaviours, the report says.

For children who are talented, motivated, goal-driven and collegial, and thus more likely to weather the storms of life, cognitive skills aren't enough. They need to be combined with social and emotional skills, which include conscientiousness and emotional stability.

The report stresses that "skills beget skills". They build on each other, and the earlier kids start acquiring them and the firmer their foundation the more skills are gained and the better the kids do in life.

You may say that children from "good" homes will acquire social skills from their parents without any fuss. That's fairly true and it's why, apart from making attendance at preschool universal, early intervention programs are best targeted at disadvantaged families, offering parents training and mentoring.

But though an early start is best, children's acquired skills remain malleable through adolescence. Programs aimed at older children emphasise teachers' professional development. Among adolescents, mentoring seems to work well, while hands-on experiences in the workplace can instil skills such as teamwork, self-efficacy (strong belief in your ability to reach goals) and motivation.

Improvements in social skills don't necessarily require major reforms or resources but can be incorporated into existing curricular and extracurricular activities, the report says. A lot of social and emotional skills can be gained from sport, arts clubs, student councils and voluntary work.

The report finds that recent developments allow us to measure social and emotional skills reliably within a particular culture and language. I reckon that as long as we retain our obsession with measuring and comparing academic performance we need to balance this with regular measurement of progress in acquiring social skills.

Surely our econocrats are bright enough to see that.

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We're not taking productivity seriously

Given our obsession with materialism, productivity "isn't everything, but in the long run it is almost everything," as Paul Krugman famously said. If so, the intergenerational report's consideration of the topic is quite inadequate.

It's partial in both senses. It mentions most of the key factors that influence productivity improvement - defined as increased goods and services produced per hour worked - but doesn't do justice to many, including climate change.

That's partly because, though the report purports to be about the future of the economy, its real target is Treasury's eternal top priority, the future of the budget balance.

But it's also because the econocrats are leading us towards their preferred policy response to our alleged productivity problem and away from those responses their "priors" - preconceived beliefs about how the world works - cause them to disapprove of.

There are two broad approaches to government efforts to improve productivity: one which involves more intervention and spending and one which involves less intervention and little change in spending. Guess which one Treasury's priors lead it to favour?

For the past 200 hundred years, most of the world's productivity improvement has come from technological advance - people inventing better machines and thinking of better ways to do things.

But the other fish Treasury wants to fry prompt it to embrace an extreme view held by a few American economists that we've entered a period of much less rapid technological change.

When you consider all the disruption the digital revolution is unleashing on so many industries this is hard to believe.

In the era of the knowledge economy, you'd expect much long and earnest discussion about what governments should and shouldn't be doing to encourage acquisition of the "human capital" that comes from education and training.

Should we be cutting budgetary support for science and research and development? Is now the right time to be pushing university funding off the budget and on to students and universities' money-making schemes?

Why would a government that professes to believe in "equality of opportunity" welch on its professed support for the Gonski reforms to school funding? Why would it view Gonski as about private versus public rather than about lifting the future participation and productivity of kids at the bottom of the distribution?

Instead, the issue of human capital is airily dismissed with the line that "there is little evidence that slower productivity growth has been the result of inadequate investment in skills, education and innovation more broadly".

Maybe. But it's probably equally true there's little evidence it hasn't been. All you're really saying is that there's little evidence - because we've never been willing to run to the expense of adequately measuring such a vital ingredient in our future wellbeing.

The other key element of productivity improvement that gets short shrift is public infrastructure spending. To what extent are its inadequacies limiting the productivity of businesses and adding to commuting times (an important part of our wellbeing that doesn't show up in gross domestic product)? But do workers who spend an hour getting to work arrive at their productive best?

No discussion of our present and future productivity performance is adequate without assessment of the role being played by our policy of high immigration. But all we get is the throwaway line that "there is some evidence that" high levels of migration increase productivity because our focus on skilled migration raises the workforce's average skill level and because "migrants can be highly motivated".

This is true and quite dishonest at the same time. It minutely examines the dog in the room while studiously ignoring the elephant. What economists know but try not to think about - and never ever mention in front of the children - is that immigration carries a huge threat to our productivity.

The unthinkable truth is that unless we invest in enough additional housing, business equipment and public infrastructure to accommodate the extra workers and their families, this lack of "capital widening" reduces our physical capital per person and so reduces our productivity.

Think of it: the very report announcing that our population is projected to grow by 16 million to 40 million over the next 40 years doesn't say a word about the huge increase in infrastructure spending this will require if our productivity isn't to fall, nor discuss how its cost should be shared between present and future taxpayers.

No, none of that. Just another repetition of that peculiarly Australian doctrine that pretty much the only way to improve productivity is to engage in unceasing micro-economic reform.

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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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