Four dysfunctional economic ideas

| July 17, 2015

Australia is holding on to some economic ideas that have served us well in the past, but won’t in the future. Ian McAuley says we need to break from these ideas that are holding us back.

In 1935, when John Maynard Keynes was struggling with prescriptions to break from an economic model that had clearly failed, he wrote: “The difficulty lies, not in the new ideas, but in escaping from the old ones.

Australians are holding on to four economic ideas that have served us well in the past, but which will not do so in the future:

  • high profits will continue;
  • competitiveness is all about cost;
  • foreigners will provide our investment capital;
  • economics is about class struggle.

Expectations of high profits – think realistically

In their book Triumph of the optimists: 101 years of global investment returns, Elroy Dimson, Paul Marsh and Mike Staunton show that of the 16 “developed” countries they studied, Australia enjoyed the second highest equity returns over last century. Ours at 7.5 percent real was pipped only by Sweden. Most countries were in the 4-5 percent range.

There are many reasons for our high returns, most obviously the benefit enjoyed by “settler societies” – nations developed on the basis of European occupation, with easily won natural resources. USA, Canada, New Zealand and Australia all fit that description – and all have had impressive economic growth compared with the Old World countries. Another benefit is that those same countries have been largely free of armed conflict on their soil – certainly in comparison with the wars that devastated Europe. (Note that Sweden shares this benefit with New World countries.)

It would be amazing if, over 217 years of using and extracting natural resources at a rate far greater than the previous inhabitants had done, Australian investors had not enjoyed high investment returns.

High population growth has also helped investors, providing a growing domestic market and assured returns for property developers.

Governments too have played their part, in building infrastructure (most notably the rapid development of railroads in the 1880s), developing institutions, and in providing education and social insurance. As in Bismarck’s Germany, Australia’s policymakers appreciated that education and social insurance were justified not only in terms of social equity but also in terms of supporting a productive workforce.

Also, governments supported corporate profitability by shielding investors and workers from the full force of competition, through protective tariffs and sanctioned restrictive trade practices, helping sustain wages and profits up to around 1980. While those days are behind us, their legacy is the idea that governments should protect us from developments that might upset the established order and protect those who enjoy economic rent.

Most of these favourable conditions are unlikely to endure. Commodity booms are far apart (our previous one was in the early 1970s), each one has had to spread its benefits over a larger population, and other countries, more desperate for foreign earnings, also have natural resources. And, as William Bourke points out in this forum, high population growth is neither assured nor necessarily desirable.

Yet expectations of high profits persist. The Reserve Bank in its latest bulletin finds that firms are still setting hurdle rates for new investments of around 15 percent, but the days when we could get that sort of return are behind us – perhaps forever. We (not only businesspeople but also personal investors and fund managers) have to lower our expectations on returns.

For people conditioned to easy returns, a lowering of returns may seem to be dismal prognosis. But the upside is a re-direction of investment horizons to the longer term. We may be less likely to engage in short-term speculation (such as real-estate), and redirect our funds to investments with modest but enduring returns, such as renewable energy. It may mean we develop industries based on deep specialization – industries that take a long time to develop but which, once developed, command a secure place in the market.

Commodity-based competitiveness – think rather of customers and value chains

Our mining, agricultural and horticultural industries are outstanding for their cost-competitiveness. (Unfortunately commodity markets can be ruthless – low costs do not always lead to high profits.)

Their competitive success has conditioned our attitude to competitiveness. While our miners and farmers clearly see quality and reliability as important, their main concern has been about containing costs – that’s what commodity competition is about. The idea that competitiveness is all about containing costs has pervaded the thinking of businesspeople and policymakers alike.

Ross Gittins, quoting Hugh Mackay, points out that competition should be about focussing on your customer, not your competitors. That means developing products and services that go along the value chain all the way to the ultimate consumer, if possible. Deep specialization, as mentioned above, is not just about having the best products on the market. It’s also about brand recognition and reputation and well-established relationships with customers.

That has been the basis of enduring competitiveness in Germany and Switzerland, particularly among Germany’s Mittelstand private companies (far less concerned with immediate financial ratios than our public companies). It’s why Switzerland has been unharmed by its steep currency revaluation. While our boom-time revaluation played havoc with our trade-exposed industries, Switzerland has been able to retain its markets in products ranging from machine tools to chocolates.

Reliance on foreign investment – think about rolling our own  

A customer focus as described above is possible only if our firms are in control of the value chain. Unfortunately many Australian manufacturers that have disappeared from our shores were prohibited from exporting by franchise restrictions imposed by overseas parent companies. Reliance on foreign capital is a quick but insecure way to develop an industrial base.

More basically, only a starry-eyed optimist would believe we can go on relying on foreign capital inflows to satisfy our insatiable appetite for imports. Since 1988 our foreign debt has doubled – from 30 percent of GDP to 60 percent, and even the recent mineral boom hasn’t achieved a surplus on current account.

Class conflict – think about sharing our value-added

Nineteenth century industrialisation was based on two factors of production (to use economists’ terminology) – labour and capital.

Capitalism’s success relied on developing institutions to mediate between the interests of capital and labour. In Australia those institutions included the Tariff Board, the Conciliation and Arbitration Commission, the two main political parties, trade unions and employers’ organizations, to name the main ones.

They have served their purpose well, as is demonstrated by the failure of those countries without such institutions.

But, as the industrial economist Mancur Olson pointed out, institutions based on sectional interests can work against the wider collective interest. (In fact, historians such as Luke Slattery suggest that Australia got a go-on in Macquarie’s time because the class divisions of the Old World had no relevance in the young nation-to-be.)

We now live in a world where words such as “labour” and “capital” have very different meanings to those they had in earlier times. Physical capital has become cheap and abundant – $100 000 and an ABN will get one set up in any number of businesses. But the capital that counts, human capital, is scarce, and it’s inseparable from “labour” – it’s embodied.

There will still be oil refineries, car plants and other industries characterised by large accumulations of expensive physical capital. There are still firms in industries such as hospitality and accommodation where there are exploited workers. The growth industries, however, are more likely to be those where divisions between “capital” and “labour” and “bosses” and “workers” become meaningless. Their business models will be about creating customer value and sharing the surplus among those who have contributed to that surplus.

Yet we still have institutions claiming to represent the separate interests of “employers” and “employees”. We still carry a model of the economy in which firms (and governments) create “jobs” for grateful employees to accept, rather than a model in which we see opportunities for people to contribute to our economic well-being, in whatever way they can.

In their contributions to this forum Andrea Warr and David Coleman suggest that our old forms of industrial organisation and thinking about “work” are not functional. If we carry on as we are we may be heading to high levels of technological unemployment and deep divisions between those few fortunate enough to have work in the new knowledge economy and a majority with little opportunity to make a useful economic contribution, and condemned to a life of relative (and absolute) poverty.

If our future is to see all people contributing in accordance with their capabilities, and drawing adequate rewards from their contribution, we need new ways of thinking about how we structure our economy.

With enough goodwill among businesspeople, policymakers and 24 million citizens a vision for Australia will emerge, but the first task is to break from ideas that are holding us back.