AFR: How to Kickstart the Economy

With official confirmation that national income has been falling, as predicted in Ross Garnaut’s book, Dog Days, attention must now turn to arresting the decline. Australians will not be able to rely on commodity prices returning to the 140-year highs reached in 2011. China’s slowing steel output will cause ongoing weakness in iron ore and coking coal prices. Any revival in national income growth must come from a large depreciation of the Australian dollar coupled with wage moderation and a pick-up in productivity growth.

Real wages have been falling, as they did during the global financial crisis. But to expect working Australians to bear the entire burden of adjustment to lower mineral prices would be unfair and self-defeating. Confronted with even harsher reductions in real wages, workers would save more and spend less, causing consumer spending to detract from growth.

Australia’s official cash rate is much higher than that of the US, Japan and the EU, as they engage in exceptional monetary easing to stimulate their economies. A further reduction in Australia’s cash rate would help bring the dollar down. Yet the Reserve Bank has reiterated its intention to keep the cash rate unchanged for the foreseeable future, apparently for fear of inflating the housing bubble. Capital requirements for mortgage lending could be increased to deflate the housing bubble, but this policy has not found favour within the Reserve Bank or in Canberra.

A combination of falling iron ore prices and signs of a US economic recovery is contributing to recent weakness in the Australian dollar. But in the absence of further monetary easing in Australia, substantial falls in the exchange rate will depend on the central banks of major developed economies tightening their monetary policies. This does not appear in prospect in Europe or Japan, though some modest tightening is expected in the US.

The Australian dollar’s depreciation needs to be large if competitiveness is to be regained. And it needs to be coupled with strong productivity growth. What matters for our competitiveness is the difference in productivity growth rates. Suppose future labour productivity growth in our major competitors averaged 1.5 per cent per annum. A continuation of Australia’s recent healthy productivity growth rate of 2.0 per cent per annum would give us a boost in competitiveness of only 0.5 per cent each year. Contrast that with the 20 per cent currency depreciation that Victoria University’s Centre of Policy Studies estimates is necessary to prevent Australian incomes from falling further.

Lifting Australia’s productivity growth rate is necessary but insufficient to boost our competitiveness. How can this be done? An unintended benefit of our strong currency is the heavy competitive pressure it has put on our exporting and import-competing industries. As the Reserve Bank points out, many trade-exposed industries are responding with improved productivity.

Around 30 per cent of Australia’s historical productivity growth has been from less profitable businesses closing down and releasing capital, labour and skills to emerging businesses with high productivity. Locking unproductive businesses in place through government subsidies simply delays the inevitable. Some of the money could better be used to support and retrain displaced workers.

With almost 90 per cent of the Australian population living in urban areas, wise investment in urban transport infrastructure to reduce the time taken to transport people and goods is a valuable source of productivity growth. And reform is needed to counter over-investment in electricity poles and wires in response to a regulated high rate of return.

More generally, the non-traded sector, shielded from international competition, is dragging down Australia’s productivity performance. Careful exposure of these industries to competition, an objective of the current review of competition policy, could lift Australia’s overall productivity performance.

Investing in skills and creativity is the pre-eminent source of productivity growth in modern Australia. Though more government funding will not, of itself, achieve this result, cutting back on their funding risks consigning Australia to ongoing reductions in national income.