Australia’s choice: the ‘high road’ to productivity or a race to the bottom

It is not easy to devise a solution to Australia’s productivity slowdown when a shared understanding of the problem is so elusive. While there is recognition among policy-makers that productivity is a…

There is little evidence to support the belief that Australia’s productivity declines are linked to the need for labour market reform. AAP

It is not easy to devise a solution to Australia’s productivity slowdown when a shared understanding of the problem is so elusive.

While there is recognition among policy-makers that productivity is a key driver of growth, competitiveness and living standards, there is much less agreement on the sources and measurement of productivity performance, and consequently on the policies that may contribute to a sustainable improvement in performance.

The need for such improvement has been sharpened and made more urgent by two separate but related problems that have recently received considerable public attention. The first problem is the impending fall in Australia’s terms of trade from the heights reached during the commodity boom.

The unprecedented rise in our terms of trade as a result of increased commodity prices delivered a massive boost to the growth in our national income in the early 2000s, helped to shield Australia from the worst of the global financial crisis and made our economy the envy of the world. However, it masked a second problem which is the underlying deterioration of Australia’s productivity performance since the 1990s.

While this problem could be safely ignored, and was ignored in the past, with rising terms of trade taking up the slack, it is now fully exposed by the turnaround in our terms of trade as the commodity cycle runs its course. There were warning signs but a cyclical event was confused by many policy-makers and commentators with structural change.

Our report for the McKell Institute Understanding Productivity explores Australia’s productivity slowdown and the policy measures that are being proposed to address it. The report finds that just as the slowdown was previously ignored, it is now misinterpreted and exaggerated to justify measures that may have little or no relevance to our future productivity performance, and which may themselves have contributed to the slowdown.

The most common measure of productivity performance is labour productivity, which measures output per unit of labour input. The slowdown in Australia’s labour productivity growth in the early 2000s has less to do with the waning of the 1990s microeconomic reform agenda than the subsequent increase in total employment and, additionally, at least since the global financial crisis, the decline in output growth.

Commentators have argued that structural change should be facilitated throughout the economy in order to reinvigorate productivity growth. Some forms of structural change may well do so, particularly those which embody new technology and innovation, but the change associated with the deregulation of product and labour markets has simply shifted much of the jobs growth to low productivity sectors. This means that structural change has detracted from rather than enhanced labour productivity growth.

The report also examines the decline in “multi-factor productivity” (MFP), which is a more comprehensive measure of productivity performance encompassing not only labour inputs but also capital and other sources of productivity. The report finds that this decline, far from being generalised, is the result of large falls in productivity in a small number of specific industries, notably mining, utilities and agriculture.

The decline in MFP in mining and agriculture reflects well understood and quantified impacts of factors such as drought and large increases in capital expenditure without a corresponding increase in output. Most of the factors are temporary, as may be seen in the case of mining where huge levels of capital expenditure will eventually be offset by rising output as productive capacity is brought on stream.

In addition, higher commodity prices have encouraged the exploitation of high cost mineral deposits. In effect, these deposits require more inputs of capital and labour to achieve the same level of output as more easily accessible and higher grade deposits extracted previously. This is simply a playing out of the long recognised phenomenon that the mining sector is subject to diminishing returns to scale.

In the case of utilities such as electricity, gas and water, the recent substantial increase in capital investment was required to compensate for inadequate investment and large employment losses in the context of privatisation and corporatisation in the 1980s and 1990s. The apparent “productivity miracle” in utilities during this earlier period was mainly due to short-term profit maximisation through unsustainable cost-cutting.

The surge in utilities investment in the 2000s was also promoted by policy measures to improve security of supply (eg. desalination plants) or quality of supply (eg. increased telecommunications coverage). There is now clear evidence of “gold plating” of utilities capital expenditure. Ironically, such gold plating can be viewed as the outcome of the same neoclassical economic thinking and policies that provided a rationale for the initial privatisation and corporatisation of these assets.

These policies also provided for a pricing regulator to ensure monopoly infrastructure and utilities suppliers did not abuse their market power. However, it has long been recognised that it is difficult, if not impossible, to establish a pricing system that can achieve such multiple and sometimes conflicting economic, equity and environmental objectives. The pricing regulation of Australian utilities is a case study of these difficulties.

Finally, the report finds that other factors can account for much of the remainder of the MFP decline, especially large swings in capacity utilisation rates over the last decade. Record high capacity utilisation rates over the 2000s were achieved up to 2007 but these dropped rapidly to much lower levels in response to the global financial crisis. Both excessive capacity utilisation and low capacity utilisation give rise to productivity declines.

In theory, the methodology used to calculate MFP is meant to capture and control for these effects, and in doing so largely discount their negative impact on productivity. However, due to a range of data and conceptual problems, these effects are not adequately captured, resulting in the large ‘apparent’ decline in MFP over the last decade which is now the cause for so much concern.

Given that this decline in MFP can be adequately accounted for as the outcome of a number of either temporary or policy-induced effects, the report finds no evidence to support the claim that the decline was due to factors such as changes to the industrial relations regime or excessive business regulation. Indeed, the period of most significant productivity decline coincided with the most radical deregulation of the labour market through the Work Choices legislation.

In sum, the report acknowledges and indeed emphasises that improved productivity is central to rising living standards and sustainable economic growth. Moreover, given the prospect of declining terms of trade as the commodity price cycle runs its course – and the pressure on Australia to reposition and compete globally as a “high cost” economy – living standards will be even more dependent in the future on increasing our rate of productivity growth, particularly in trade-exposed sectors.

Australia is once again faced with a fundamental policy choice – the “low road” of narrow cost-cutting and an unwinnable race to the bottom, or the “high road” of longer term dynamic efficiency gains in a knowledge-based high wage, high productivity economy. While there is clearly a range of factors influencing productivity performance, the report proposes a “high road” productivity strategy with a focus on three empirically grounded and integrated policy measures.

These policy measures are first support for enhanced innovation capability and performance of firms, including new business models, systems integration and “absorption” of technological change; second, adoption of transformative management practices, drawing on improvements in management education and engaging with the full spectrum of talent and creativity in our workplaces; and third, expansion of participatory work organisation methods and improvements to skills formation and skills utilisation so that firms and organisations can achieve their potential.