Australia’s Poor Productivity: What’s the Issue?

There is a lot of talk about Australia’s lagging productivity at the moment.

What exactly is the issue? And how serious a problem do we have?

Productivity is a jargon term used by economists to define the amount of economic output generated per unit of input. The way economists think about this is that output is a function of ‘factors of production’ – of which the two key ones are labour and capital.

When people say ‘productivity is falling’ what they actually mean is that ‘the rate of annual growth in productivity is lower than it used to be.’

Economist Saul Eslake discussed this issue in a paper entitled Productivity: The Lost Decade he gave at a conference last year.[1] Eslake pointed out that in the 1980s Australia’s ‘multifactor productivity’ grew by 0.7 per cent each year. Then in the nineties it jumped dramatically – to 1.6 per cent each year. But in the first decade of this century Australia’s annual productivity growth has been essentially flat.

Productivity growth is a very desirable thing. Think of Australia as a giant machine, with ‘inputs’ (principally labour and capital) going in to the machine, and output (national income) coming out. Let’s imagine we put enough units of input into our machine in 1990 to get exactly 100 units of output.

But then throughout the nineties our productivity improved each year by 1.6 per cent. When you do the maths this equates to a 17 per cent increase by the end of ten years. So by the year 2000, for exactly the same amount of inputs, we were getting 117 units of output. That’s like getting 17 units of output for free!

A more technical way of saying the same thing is that productivity growth is the main driver of long term increases in real, per capita income. That is why economists and policymakers spend so much time talking about productivity.

Recently the international consulting firm McKinsey issued a very instructive report entitled Beyond the Boom: Australia’s Productivity Imperative.[2] The report pointed out that Australia has been doing extremely well over the past twenty years: our per capita income has risen from sixteenth in the OECD in 1990 to sixth in 2010. In the six years from 2005 to 2011, Australia’s ‘gross domestic income’ rose from $815 billion to $1042 billion.

But this rosy story disguises a steady reduction in productivity growth (the same reduction that Saul Eslake’s paper highlighted.) In fact, according to McKinsey, multifactor productivity grew 2.4 per cent a year from 1993 to 1999; 0.9 per cent a year from 1999-2005; and from 2005 to 2011 it has actually dropped by 0.7 per cent a year.

McKinsey’s analysis breaks down the recent growth in national income to explain what is happening. Of the $227 billion growth from 2005 to 2011, there were five components:

• 38 per cent came from a favourable movement in the terms of trade. (This is the ratio of the price of Australia’s exports to the price of our imports. RBA Governor Glenn Stevens gave a great explanation of this recently: in 2005 one shipload of iron ore from Australia was worth 2,200 flat screen TVs from China; by 2010 it was worth 22,000 flat screen TVs.)[3]
• 53 per cent came from additional capital investment.
• 20 per cent came from growth in labour (that is, the total number of hours worked in 2011 was 20 per cent higher than in 2005, reflecting more people in the population and more of the population working.)
• 8 per cent came from labour productivity (that is, more output per hour worked)
• The effect of capital productivity was negative 19 per cent (that is, for each dollar invested in capital, the amount of income generated was 19 per cent lower in 2011 than in 2005.)

In other words, while Australia’s national income grew markedly between 2005 and 2011, the growth did not come from using inputs more efficiently. On the contrary, multifactor productivity (that is, labour and capital combined) actually fell. Our national income grew because of a surge of capital investment (that is, there was more capital at work in 2011 than in 2005, thanks largely to huge investment in mining and resources); because there were more people doing more work (which helps total national income, but not per capita income – as well as having more people to do the work, you also have more people to share the income across); and because we got lucky on the terms of trade (the price of our export commodities like coal and iron ore jumped, and the price of many things we import like consumer electronics fell.)

The problem is that we cannot assume that we will continue to get a big jump in capital invested each year – in fact the evidence suggests that the mining boom is already past its peak and soon capital investment will start to drop. As for the terms of trade, it is now moving against us: in the last few months the price of iron ore per tonne has fallen sharply.

McKinsey's analysis raises two key questions. Firstly, what has caused the decline in productivity in recent years. Secondly, if we want to fix the problem, what should we do?

Eslake’s paper, quoted earlier, highlights some sector specific explanations. In particular, the huge increase in labour and capital in the mining sector has tended to suppress productivity in the short term because mining projects have long lead times (during which time you are putting in inputs but getting no output.) The major factor he highlights, though, is that the microeconomic reform process has largely come to an end.

For twenty five years, from the early eighties, there was a steady process of opening up more and more of the economy to competition, moving many businesses from government to private sector ownership, reducing tariff barriers, and making our tax system more efficient through measures like the GST. For a number of years we were getting the productivity benefits from this process, but that has now come to an end.

If we are to return to enjoying annual improvements in productivity, then, we need to restart a program of microeconomic reform. The chairman of the Productivity Commission, Gary Banks, gave an enlightening speech on this topic in 2010.[4] He highlighted some priorities:

• pursue productivity enhancing reforms that reduce business costs and enhance the economy’s supply-side responsiveness, while being ‘fiscally parsimonious’
• Reduce government assistance to manufacturing (or other) activities that is not justified by genuine market failures
• Reform government procurement (including defence procurement)
• Target infrastructure projects that do not yield a net social benefit
• Target human services programs which could be delivered more cost-effectively (especially health services)
• Reduce regulatory compliance burdens, as well as constraints on flexibility and adaptability at the enterprise level
• “If we are to secure Australia’s productivity potential into the future, the regulation of labour markets cannot remain a no-go area for evidence-based policy making.”

Of course, as a public servant there are some things that Gary Banks is not able to say. But to any objective observer it is pretty obvious that the Gillard Government’s policies go in precisely the opposite direction from what is required to increase Australia’s productivity.

The Gillard Government has been enthusiastically reregulating and making it harder and more expensive to do business (in sectors as diverse as road transport, coastal shipping and banking); cranking up government assistance to sectors such as automotive (around $700 million a year) and “green energy” (a $10 billion allocation to the Clean Energy Finance Corporation); and reregulating the labour market (while removing proven safeguards against union thuggery like the Australian Building and Construction Commission).

What’s the first and most important step to improving Australia’s productivity performance? Toss out the hopeless Gillard Government.

[1] Eslake, S, ‘Productivity: The Lost Decade’, Paper at RBA Conference, The Australian Economy in the 2000s, August 2011, http://www.rba.gov.au/publications/confs/2011

[2] McKinsey Global Institute, Beyond the Boom: Australia’s Productivity Imperative, August 2012, http://www.mckinsey.com/insights/mgi/research/asia/australia_productivity_imperative
 

[3] G Stevens, ‘The Challenge of Prosperity’, Address to CEDA Annual Dinner, Nov 29, 2010, http://www.rba.gov.au/speeches/2010/sp-gov-291110.html

[4] G Banks, “Successful reform: past lessons, future challenges “, Speech to Australian Business Economists, 8 December 2010, http://www.pc.gov.au/speeches/successful-reform