AFR: We Will Have to Run to Stand Still

Published in the Australian Financial Review on August 5, 2014

Co-authored by Janine Dixon

With the passing of Australia’s unprecedented mining investment boom, the economics profession has turned to working out how to sustain Australian jobs and incomes in an ageing population and with declining mineral prices. Some economists, led by Ross Garnaut, see this as a large challenge. Others, such as John Edwards, see it as a small one. The Australian Treasury’s position is somewhere in between. Yet despite differences of opinion on the size of the task, economists generally agree on three preconditions for Australia making a successful transition to a more diversified economy capable of producing rising incomes: the exchange rate must fall, wage inflation must not follow and productivity must rise. 

Based on Australians’ experience of 23 years of recession-free economic growth, we have come to expect constantly rising real incomes. As economic modelling by Victoria University’s Centre of Policy Studies reveals, for the rest of this decade much of the growth in Australia’s Gross Domestic Product (GDP) will be from large volumes of minerals exported by the predominantly foreign-owned mining sector. While these exports will increase GDP they will increase the incomes of Australians by much less. Falling mineral prices will further curb the mining sector’s contribution to incomes.

GDP will need to grow at almost 2.5 per cent per annum just to prevent real income per person from falling. With the ageing of the population acting as a drag on growth, achieving annual GDP growth of 2.5 per cent would require the broadest measure of productivity – multifactor productivity – to grow at 0.5 per cent a year. Multifactor productivity growth reflects how well capital and labour inputs are combined to produce output. It grows through improvements in technology and business management practices. 

While 0.5 per cent might seem a small number it would constitute a big turnaround; over the last decade, Australia’s multifactor productivity has actually declined by almost 0.3 per cent per annum. Since services provide more than 70 per cent of the nation’s GDP, this is where the productivity action will need to be. Multifactor productivity growth in services and manufacturing will require new investment embodying the latest technologies. Yet at an exchange rate hovering around 94 US cents, export and import-competing businesses are finding it hard to make the case for new investment. 

The modelling suggests the exchange rate needs to fall by around 20 per cent. With the underlying inflation rate close to the top of the Reserve Bank’s range and concerns about rising house prices, the Reserve Bank seems stymied in reducing the large interest rate differential between Australia and the rest of the developed world that is keeping our currency high. 

One way of solving this dilemma would be for the authorities to increase the amount of capital banks are required to hold against mortgage lending, enabling the Reserve Bank to lower the cash rate without further inflating the housing bubble. This is an idea floated in the interim report of the inquiry into Australia’s financial system released last month headed by David Murray, albeit for another purpose.

In the absence of some such policy shift, Australia would have to rely on the US Federal Reserve to reduce the interest rate differential by increasing rates in America. Contracting out monetary policy to another country might not be a good idea.

Workers and the industrial relations system in which they operate are playing their part in adjusting to declining income from overseas through wage restraint. Real wages are falling. Ongoing weakness in the labour market during this transition period is likely to cause further reductions in real wages.

Multifactor productivity growth has been declining in developed countries since the mid-1990s, raising concerns that rich countries have reached a technological plateau. Information and communications technology is no longer contributing to productivity growth in the developed world and the pace of innovation has slowed. 

Achieving annual multifactor productivity growth of 0.5 per cent therefore will be difficult. Even then, we would only be treading water – preventing the real incomes of Australians from falling. It will require a reform program that: promotes competition in industries – such as utilities – not exposed to competition from abroad; supports skills formation at schools, training colleges and universities; and invests in productivity-enhancing infrastructure. Without such reforms, Australians will need to get used to declining living standards.


Craig Emerson is an Adjunct Professor at Victoria University’s College of Business. Janine Dixon is a Senior Research Fellow at Victoria University’s Centre of Policy Studies.