Adapt to the Tide of Change, or Perish

Warwick J. McKibbin
Warwick McKibbin
Warwick J. McKibbin Former expert - Economic Studies, Center on Regulation and Markets, Distinguished Professor of Economics & Public Policy - Crawford School of Public Policy, The Australian National University

July 30, 2012

Daily news of job losses and closure of high-profile production facilities again raises the question of what should governments do to deal with the apparent rapid transformation of the Australian economy and particularly the problems in the manufacturing sector.

The causes are many in number and vary significantly by sector. It is misleading to lay the blame for everything on a strong dollar or the carbon tax or changing government policy or the unions or poor management practices. In fact, what is needed in framing appropriate policy is a detailed understanding of the structural adjustment that Australia is facing.

In the political debate there is a tendency to oversimplify the causes. There is an overwhelming desire to find a simple common cause for everything so blame can be allocated. There is also a tendency to reject outright a driver of change that might be important because it can’t explain everything.

There are many causes of structural adjustment and many shocks occurring at the same time. Policy should be designed to respond in detail to these where possible, but within an overarching framework of what is happening and a focus on how individual policy responses fit together in a consistent fashion.

Put simply, there are many problems facing the manufacturing sector as a whole in many countries. Australia is not alone in dealing with structural adjustment.

The issues are best thought through by understanding what drives businesses to close. The problems occur when the costs of producing goods exceed the price that can be achieved from selling goods in a competitive market. Input costs include the price of labour (driven higher by labour market rigidities); the cost of capital (driven higher through financing costs); the cost of energy (driven higher, particularly in electricity, by years of neglect in infrastructure spending on generation and distribution and further increased by the carbon tax); and costs of government regulation.

After accounting for all the input costs, the strong currency is making it even more difficult to compete in foreign markets or with foreign imported products. Each sector is affected differently by each of these forces.

It is worth drilling down on the role of the carbon tax: $23 is a substantial price and it is higher than in other countries. It is not a coincidence that some industries are adjusting more quickly than others to the tax.

In the 2008 Treasury report on Australia’s low-pollution future, it is clear where the negative effects of a carbon price are focused. That report assumed global action but without the rest of the world taking action the effect on Australia will be larger than estimated due to additional competitiveness impact. The report summarises results under the carbon pollution reduction scheme (CPRS) where the government targets a 5 per cent reduction in emissions below 2000 levels by 2020.

In this scenario, the most affected sectors and the output decline by 2050 are coal mining (minus 30 per cent); oil refining (minus 37.7 per cent); aluminium (minus 45.2 per cent); and coal-fired electricity (minus 71.5 per cent).

This is the long-run outlook for these sectors. In the Treasury modelling, this takes time to unfold as the constraint of ever rising carbon prices kicks in. In reality, an industry facing such a future would begin to divest as soon as it could mobilise its funds out of these declining sectors.

It should be no surprise that we’re already seeing job losses in these sectors. It is what the carbon tax is designed to achieve. Politicians who say the carbon tax has no impact on jobs are as wrong as those who argue it is the entire story.

The carbon tax is only part of a complicated structural adjustment. The world economy is fundamentally changing and always has. What is different now is the scale of the effect of the emergence of the big emerging economies into the global economy.

As many parts of the emerging world (particularly China and India) enter the global economy, there is a fundamental transformation of production and consumption patterns around the globe.

Manufacturing has been declining as a share of gross domestic product in Australia for decades. Some things we produce are no longer competitive with foreign goods that are very similar, primarily due to the input cost structure outlined above.

On top of this decline, Australia is experiencing a mining boom which further appreciates the currency and so makes non-mining goods more expensive. Sectors that have some degree of flexibility on input costs can offset the rising currency by lowering input costs. Sectors that have rigid labour costs such as the automotive industry find it difficult to adapt. Energy-intensive industries that need high-cost energy inputs find it hard to adapt. Capital-intensive companies that need access to capital but face a high cost of funds because of global economic risk and domestic political risk cannot borrow and therefore cannot easily adapt.

Australia is being swept along by this global tide. Should we resist this change or should we adapt to the change? History gives a clear indication of the answer. Successful economies are those that adapt both their economic structures and their social structures to ride global waves of change.

A good place to start is where the rigidities are sharpest and the sources of this inflexibility. In some cases it is government that is to blame, in others, as pointed out by Treasury, it is the managerial practices in companies. One would expect the market to sort out the managerial problems eventually, but governments have a capacity and an obligation to the public to change what they do and how they do it.

As key economic managers in the Reserve Bank of Australia and Treasury have made clear, Australia has an big challenge ahead, but clearly great opportunities.

It will require a bipartisan acceptance of the national interest. It will require an understanding that governing for the few vested interests in unions or companies or regions should come second to the interest of the majority of Australians.

It will require a major role for the Productivity Commission in focusing on the costs and benefits of major structural policies. It will require an understanding of unintended consequences of legislation that locks in higher costs in labour markets, capital markets and energy markets.

It is hard to see how this change in culture can occur in a Parliament governed by minority interests.