It's time to put the nation's prosperity before politics, says Don Argus

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WHILE Julia Gillard has been busy selling the virtues of the Australian economy, I have been involved with a forum, composed of business leaders, senior bureaucrats, bankers, scientists, venture capitalists and a leading author on world affairs.

At the risk of stating the obvious, one of the conclusions from the forum was that we have entered an era without political leadership and the courage to address difficult issues. It is unfortunate because at this time so many problems transcend borders, from regional conflicts, refugees, climate change, threats to global market stability. These are a result of years of poor economic judgment in some jurisdictions, terrorism, potential cyber attacks that threaten intellectual data and the security of food and water.

So who is going to lead us through these challenges? There is not much faith in the once-dominant G7 nations. The G20 is heavily criticised for being "every nation for itself" and, in the eyes of some seasoned northern hemisphere bureaucrats, it's just another fixture in the timetable of international meetings. 

Attempts to get a commitment from world leaders on carbon emission abatement and emission trading schemes have failed. The recent Rio summit on sustainable development ended with the British Deputy Prime Minister Nick Clegg reportedly disappointed that some developing nations were concerned about implications for their growth if they submitted to specific goals.

With Europe in an economic mess, one could conclude that it will be difficult to see any economic growth from the Western world for some time. I am more optimistic about the US. Anyone who believes that America is in some kind of irreversible decline has chosen to ignore the entire history of the US and its people. But the reality remains that the Western world faces a challenging period ahead.

The GFC and China's ability to power its way through the slowdown have persuaded some bureaucrats and commentators that a manipulated form of capitalism is the wave of the future.

Those who present this thesis, of course, forget that for all its failings, the free market form of capitalism has generated a broad prosperity through booms and busts for many generations.

Equally, most intelligent commentators acknowledge that prosperity does not lie in printing unlimited amounts of money or rising indebtedness, but in becoming more productive. This is readily apparent in Europe, where for too long poor productivity was papered over with lax fiscal policy and rising debt. Western world economies are now awash with debt and at some point they will need to deleverage to get on the path of sustainable growth.

Because of the gravity of these issues, I want to outline what they mean for Australia. I will also outline how we can lift the tone of debate in this country to deal with the challenges beyond the next budget and leave a lasting legacy for future generations.

Debt and deleveraging

THE past few years have made us all acutely aware of the pitfalls of carrying too much debt. When debt is high, your welfare and peace of mind can deteriorate very quickly, even if your income falls by only a small amount. Of course, this is an age-old lesson but many people are heeding it for the first time, or the first time in a long time.

Having said that, the only deleveraging that has really occurred in Australia so far has been by businesses, which you can see in the first chart (graph 1). In contrast, government debt continues to rise and household debt has been tracking sideways relative to the size of the economy.

Some recent work by the Bank for International Settlements suggests that when gross household debt passes 85 per cent of GDP, it becomes a drag on economic growth. Australia's household debt amounts to about 110 per cent of GDP and therefore is in excess of that threshold.

As a result, the capacity of the household sector to drive growth is very limited, a problem besetting most of the developed world.

On government debt, the Bank for International Settlements research also shows that when gross government debt rises above 85 per cent of GDP, debt becomes a drag on economic growth.

While Australia comfortably meets this hurdle, many developed countries do not.

You can see this in the next chart (graph 2), which shows IMF estimates of advanced countries' debt-to-GDP ratios.

I will elaborate on Australia's fiscal situation in a moment, but the global backdrop is very concerning. The IMF's numbers tell us that one-third of developed countries now have government debt above the 85 per cent of GDP threshold. These include the problem countries of Greece, Italy, Ireland and Portugal but also large and economically important nations such as the US, Japan, Britain and France. In fact, the aggregate debt-to-GDP ratio for all 30 advanced countries is well above the 85 per cent threshold at 107 per cent.

Now if this metric is so important, why have politicians and bureaucrats allowed their economies to deteriorate to the extent that there are questions over the ability to service debt? I could argue that some countries in the developed world are technically bankrupt -- in other words, they cannot pay their debt obligations.

I have spent most of my life in organisations where clear, quantifiable goals are indicators of success. In high-performance organisations, measurement is a way of life. Leaders in such environments must link those measurements to high-performance outcomes. It is not enough to measure things -- you must measure the right things.

In the business world, it is usual for leaders to give markets some guidance on prospects within the parameters set by various governance bodies. There is accountability for the integrity of such information, with severe penalties for misleading the market and its practitioners.

So I hope you will understand my scepticism about the relevance of the data the bureaucrats and politicians examine. For example, some economists are beginning to question the relevance of GDP as a long-term economic performance measure as distinct from a measure of activity.

Moreover, I would have thought that debt to tax revenue collected would warrant greater commentary if one were serious about assessing the capacity of a nation to service its debt and make judgments about the prospects for growth.

Let me drill down on some aspects of Australia's public finances for a moment. The next chart (graph 3) shows the trend in Australian government debt since 1990. Many commentators are dismissive of the upward trend because we stack up pretty well relative to other nations. But the folly of ignoring it is borne out in the analysis by the Bank for International Settlements I have outlined.

I think we bask too much in Australia's government debt metrics and have become complacent about our public finances. A low debt-to-GDP ratio does not guarantee the prosperity of our children and grandchildren. For their prosperity, our political leaders need to keep making good decisions today for the future.

It is regrettable our national debate on these issues has become oversimplified and heavily geared towards the media cycle. Our political leaders go to extraordinary lengths to publicise their financial acumen, yet closer examination finds the debate severely wanting.

Too often it is couched simply in terms of whether the government will achieve a surplus or not, and even on that issue the debate has been severely debased.

Take the most recent budget that forecast a surplus for 2012-13 and beyond. You will recall that the expected surplus was relatively small, at $1.5 billion in 2012-13 and $2bn in 2013-14.

In the scheme of things, these are tiny surpluses. In fact, they are so small I am very sceptical about whether a surplus will actually be achieved at all.

The next chart (graph 4) shows why. It compares two sets of budget forecasts, one from the 2011-12 budget and the other from the 2012-13 budget.

For each of the four years shown in the graph, the revision to the expected budget outcome was greater than the $1.5bn expected surplus for this year.

Instead of getting tangled up in all the political mumbo-jumbo around this issue, I want to go back to first principles of good financial management to identify areas that need more careful scrutiny.

In graph 5, I have constructed a simple P&L sourced from the government's budget papers, akin to the kind you would find in a company's annual report.

What conclusions do I draw from these numbers?

The most glaring observation is that growth in expenses has outpaced income -- something that is ultimately unsustainable.

Obviously the GFC weighed heavily on revenue in 08-09, but this highlights the operating leverage inherent in our public finances. In the low-growth world that will be part of the landscape for quite a number of years, reducing operating leverage will be vital if our public finances are to be sustainable.

Turning to a closer examination of expenses:

Welfare accounts for one-third of all spending and is among the fastest growing components. This line item is not an investment in Australia's productive capacity; very little of it meaningfully contributes to future growth. How welfare spending can be contained must be a key focus of policy if we are to have sustainable public finances.

Education is the fastest-growing component of spending. This is commendable in terms of fostering productivity. Similarly, spending on health is big and growing fast, and this will accelerate as the population ages. It is vital that all of the actors in health and education are motivated to be efficient. Regrettably, unions have become increasingly vocal against embedding productivity criteria in employment agreements.

Finally, it is interesting that GST revenue and the associated payments to the states are growing slowly. This puts big pressure on their finances, limiting any investment in infrastructure they need to do.

I alluded to the notion of operating leverage earlier. Remember that operating leverage for a business is a measure of how changes in revenue translate into profit. A business with a high fixed cost base usually has high operating leverage, such that small changes in revenue have a very large impact on the bottom line.

And that's precisely my concern for our nation. I think the cost base inherent in the government P&L has become so large that even relatively small changes in revenue have a big impact on the bottom line.

To highlight this point, my next table (graph 6) outlines the impact on the budget of a fall in the terms of trade. Remember that the terms of trade are the ratio of Australia's export prices to our import prices. The numbers are from the budget papers themselves and are subject to a range of simplifying assumptions but they are a useful starting point for discussion.

Australia's terms of trade have increased dramatically in recent years from the rise of China and its demand for our natural resources. But we ought not to become complacent about this and assume commodity prices will remain elevated forevermore.

I find it remarkable that a fall in the terms of trade of just 5 per cent more than expected by Treasury would wipe out this year's forecast surplus of $1.5bn two times over. Most of this impact comes through lower tax receipts, in particular company tax; the impact on tax receipts in 2013-14 is even larger. And note the operating leverage here. There are big falls in revenue but the cost base hardly changes at all.

Now let me bring in a chart (graph 7) of our terms of trade to give a sense of how large this problem could be. By any standard, our terms of trade are extraordinarily high. Most economists think they have peaked and will fall over the next few years, yet there has been almost no debate about how we will protect Australia's finances from this deterioration.

The government's apparent response has been to increase tax revenue, however ill-conceived a particular tax might be. That makes no sense to me. In a corporate setting I can tell you that shareholders would not let management using that approach survive very long. Instead of looking at what extra taxes can be levied, we need more debate about how we can get the cost side of our public finances down.

We need more debate about the welfare mentality that has become so entrenched. We need more debate about how we can make our schools, universities and hospitals more efficient and accountable. And more debate about the worthiness of proposed government investment. I am not just talking about social welfare; I am also talking about endeavouring to pick industry winners and subsidies for loss making enterprises.

Take the National Broadband Network. This is a project that is projected to cost more than $35bn. It has been touted as an important part of the solution to Australia's productivity problem. Yet we have had no assessment of it by the Productivity Commission and there was seemingly very little consideration of alternative options before the government committed to it. In a corporate setting this would just not happen without shareholder revolt.

That leads me to productivity -- or the lack of it -- which has been Australia's Achilles' heel.

Productivity

IN a low-growth world that I expect will be the norm for some time, boosting productivity must be a central focus for everyone -- government, businesses and academe. Economists and others have long recognised that productivity growth (that is, increases in the level of productivity over time) is the only sustainable source of improvements in a community or a nation's material wellbeing.

Simply put, productivity is what a workplace, a business or government agency, an industry, a region or a nation gets by way of goods and services for what it "puts in", in terms of labour, capital and other factors of production.

Most will be aware that Australia has experienced poor productivity growth for the past decade. Even more worrying is the fact that our productivity has also been falling relative to other countries, which makes Australia less competitive even before factoring in the high Australian dollar.

You can see how Australia's labour productivity has declined when compared to the US in this chart (graph 8). The productivity of Australian workers relative to their US counterparts has declined over the past decade and is back where it was in the late 1970s.

Another way to look at falling productivity is to examine the next chart (graph 9). Ordinarily falling productivity would mean that Australian living standards decline. But this is where Australia's luck comes in.

The deterioration in productivity growth was camouflaged by the unprecedented boost to the terms of trade that has occurred because of China's rapid economic development. This can be clearly seen in this chart, which is an updated version of one used by Martin Parkinson (secretary of the Treasury) in a speech last year.

It shows that the decline in Australian labour productivity growth -- the dark blue bars -- since the 1990s was substantial, but that this was largely offset by the boost in the terms of trade -- the brown bars -- such that Gross National Income growth fell only a little.

As I alluded to earlier, it is very unlikely that Australia will see an improvement in the terms of trade of the magnitude we witnessed in recent years, with many believing the terms of trade have now peaked. Take the terms of trade out of this chart and you have a dismal picture for the improvement in living standards.

If you then overlay the level of household debt and real estate prices over the past 10 years, one could become quite concerned about the impacts of deleveraging when compared with previous episodes. My experience suggests most governments do not have the fiscal firepower to support economic growth while the household sector is also deleveraging.

That means productivity growth must play a greater role in improving living standards. In recent times productivity has received greater attention in our political rhetoric, but we must be relentless in our focus on the issue if we are to secure the living standards of future generations.

Let me highlight some areas that I believe are potential risks to productivity improvements.

First, we must give our business leaders the flexibility to shape their workforces and manage their balance sheets without threats of disruption from unions and harassment from government.

This is imperative now because, outside of the resources sector, much of Australia is going through a tough patch. The impact of the strong Australian dollar, slowing global growth and fragile consumer confidence means that many businesses and households are doing it tough. If the natural adjustment that businesses need to go through is slowed down by political wrangling, union interference or poorly designed legislation, then we will harm the prospects for productivity for perhaps a decade to come.

Of course the Fair Work Act governs the interactions between workers, unions and businesses and it is concerning that we still face substantial uncertainty about how to interpret key provisions of this legislation.

If you accept the argument that we must continually strive for improved efficiency to remain internationally competitive, we do need certainty in the application of our regulatory environment to ensure that potential artificial barriers do not again impede this competitiveness.

We certainly cannot afford a return to the trends outlined in this chart (graph 10) to prevail.

The second risk to productivity that I want to highlight is the carbon tax, which will have a huge bearing on the allocation of capital and labour in this country.

The dogmatic determination by our political leaders to push ahead with its implementation without care for the enormous uncertainty already faced by business has been breathtaking.

Even those who admit climate change is occurring acknowledge that it is a relatively slow-moving process. Coupled with the fact that Australia emits fewer than 2 per cent of global CO2 emissions, this suggests there would be no harm in holding off introducing the tax until the global economy settles down. After all, Australia's ability to change the trajectory of global emissions is frankly negligible and, given the size of the levy being introduced, one can understand the bemusement of those who have investments in this country or are contemplating investment.

But the problem of us being "lone rangers" on climate change is worse than just the uncertainty it has thrust on businesses. The Europeans had the foresight to build pricing flexibility into their scheme, such that the cost burden fluctuates with the business cycle.

Not so in Australia, where the price will be fixed for the first three years irrespective of the conditions businesses face.

This puts Australia at a further competitive disadvantage. In this graph (graph 11) I have compared the cost of emitting one tonne of carbon in Australia and Europe. Australia's fixed cost of $23 per tonne of CO2 is nearly three times as much as the Europeans are paying at the moment. How can such a large cost differential be productivity enhancing for Australian businesses?

The other reality is there is no binding global agreement on carbon emissions abatement. There is no likelihood of a global agreement on carbon pricing, which at one stage was an assumption promoted by some proponents, and given the state of the global economy and the US's move to energy independence by greater use of gas, then there appears little likelihood of any global agreement in this area for many years.

Conclusion

VERY deliberately, I have made some pointed comments about policy and the tone of debate in this country. There are immense challenges before us about which I fear we are becoming complacent. Our children and grandchildren are being done a great disservice by the sloganeering politics we see at work every day.

We urgently need to take a look at the cost base inherent in our public finances. In my mind operating leverage is too high and we need to debate how we can get it down. The solution is not more taxes but a more efficient cost base.

We also need a relentless focus on productivity. The carbon tax and workplace relations system are productivity hindering, not productivity enhancing.

We all know there are major challenges ahead. Fortunately, unlike many other nations, we can navigate these challenges from a position of strength. But navigate them we must. We must not accept the status quo, for that will not guarantee that future generations experience the same standard of living that we have grown to enjoy.

And that's my message -- let's debate the issues rather than accept that Canberra knows best, assess them against what is in Australia's best interests and understand the cost-benefit of change and keep Australia competitive globally. For we will all then benefit from Australia's growth and leave a lasting legacy for future generations.

source: http://www.theaustralian.com.au/business/economics/its-time-to-put-the-nations-prosperity-before-politics/story-e6frg926-1226422919692