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Why Australian productivity is better than it looks

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Published on: Thursday, July 10, 2014

by Michael Knox - Morgans

I have a fairly positive view of the Australian economy. I have thought that growth would be higher than the consensus this calendar year. As we go through the year, growth seems to be surprising modestly on the upside and consensus is moving up to my target of 3.0 per cent. I am even more positive about growth next year because I see us benefiting from greater strength in the US economy that year.

So it was a shock to me last week to go down to the Annual Conference of Economists in Hobart. The conference of economists is an event where economists from all over Australia go to one place for a week and speak to each other in fluent nerdish. I was taken aback by how pessimistic the estimates of future Australian growth were amongst my esteemed colleagues. This seems to be the influence of the publication by Ross Garnaut of his book “Dog Days”. One paper delivered at the conference particularly attracted my attention. This was “Quantifying “Dog Days”” a paper by the Centre of Policy Studies, Victoria University. The paper was presented by James Giesecke.

To say the outlook is bad, according to this paper, is an understatement. The Australian terms of trade which peaked in 2011 has declined by 17 per cent. The paper estimates that the terms of trade will fall another 20 per cent. An orderly adjustment to this process will require a fall in real wages and a fall in real consumption. In simple terms, the outlook looks rotten as far as the eye can see.

Won’t that change if the Australian dollar falls, I asked? Well no, according to the authors of the paper. They already assume that the Australian dollar is going to fall to around US75 cents in the next few years. This generates just enough of a trade surplus to pay for the repatriation of mining profits to foreign companies. The problem I was told is low productivity growth. Productivity growth started to decline in Australia in 2005. For us to have a better and wealthier future, productivity will have to return to the levels that it was before 2000. We were told this is unlikely to occur. But is it?

Rays of hope

The first little ray of hope that the outlook for productivity may be better than is assumed in ‘Dog Days’ came in a speech by Glenn Stevens presented on 3 July 2014. On page 3 of this speech we see a chart on Labor Productivity. This chart shows that labour productivity did in fact go through its own ‘dog days’ between 2005 and 2010. Productivity fell from 2.1 per cent annual growth before 2005 to 0.9 per cent growth from 2005-2010. Since then however, productivity growth, excluding mining and utilities, has reaccelerated to 2 per cent per annum. General productivity growth has accelerated to 1.6 per cent per annum.

Why productivity has been bad

We note from Chart 1 that productivity in Australia started to fall after 2005. We also note that Chart 1 discriminates between what is happening in the economy other than in the mining and infrastructure sectors. This gives us a clue that the deterioration of productivity is centered in the mining and infrastructure sectors. What went wrong with productivity in mining and infrastructure?

Presentations that I have attended by the Productivity Commission suggest that the productivity in infrastructure has been bad because of productivity of water in infrastructure. Simply put, Australia built a whole lot of desalination plants near capital cities. In most cases these desal plants produced no water. The major exception of course is Perth where desalinated water is essential to the public water supply. Elsewhere, for example in Queensland expensively built desal plants lie idle.

Now if you put a lot of inputs into building a desal plant and it produces no output, then its productivity is infinitely low. Expenditure on desal plants has been enough to depress productivity in water infrastructure and hence the whole infrastructure sector.

The second place where infrastructure has fallen is in mining. The assumption in Australia is that this low productivity in mining has been because the mining boom has led to the mining of lower quality ore. Until recently, this has been the accepted explanation for why mining productivity has declined. However, there could be an entirely different explanation, and that different explanation generates an entirely different outlook for where total Australian productivity may go in the future.

More rays of hope

On 8 July, I attended a presentation by Dale Jorgenson. Jorgenson is a previous President of the American Economics Association. He is Samuel W Morris professor at Harvard. He delivered the annual Colin Clark Memorial lecture in Brisbane this year. Jorgenson’s speech was called “Australia and the Growth of the World Economy”. Jorgenson had a lot to say about productivity.

In Chart 2 Jorgenson showed the growth rates of the Australian economy from 1990 to 2012. He also showed the composition of that growth in terms of hours of labour; the quality of that labour; non IT capital; IT capital and total factor productivity. Total factor productivity growth is shown as the yellow area. He showed how total factor productivity accelerated from 1990-1995 to 1995-2000. Then he showed how total factor productivity slumped. Total factor productivity growth was negative in the period between 2000 and 2005. Total factor productivity was even worse from 2005 to 2012. What is happening here?

To give us an answer Jorgenson shows us a comparison of what has been happening in another resource economy like Australia. In Chart 3 we see the sources of economic growth in the G7. Jorgenson draws our attention to the country in the G7 which is most like Australia. Canada, like Australia, is a resource exporting country. Canada, like Australia, has experienced a mining construction boom between 2005 and 2012. What Jorgenson shows us is that Canada, like Australia, has experienced a slump in total factor productivity growth at the same time as this mining construction boom. Why has this happened?

Jorgenson offers an entirely different explanation of why total factor productivity has appeared to decline during the mining construction boom. He does not say that the decline in productivity occurs because of lower mining grade ore. What he does say is that the decline in productivity is a result of how the national accounts are done.

A mining construction boom increases the long term productive capacity of the mining sector. Large investments result in large increases in output but only after a lag. When the initial investment is made there will appear to be little increase in output. The result is that productivity will appear to decline in the short term. However, when investment declines as it nears completion, output will be rising. Productivity will appear to increase.

What Jorgenson suggests is that once the mining construction boom is complete, Australia will see a dramatic recovery of total factor productivity in the mining sector. This will be enough to generate a dramatic recovery in total factor productivity in the Australian economy as a whole. This more optimistic outlook for productivity generates a much more optimistic outlook for the Australian economy than the consensus.

SOURCE: Dale Jorgenson

In Chart 4 above Jorgenson shows four different scenarios for labour productivity growth in Australia in the period in front of us from 2012 to 2022. Again, total factor productivity is shown as the yellow area. The first bar on the left is the historical case from 1990 to 2012. My understanding is that most economists don’t think it is possible to achieve even this level of historical productivity in the future. Jorgenson also shows three other cases, a pessimistic case, a base case and an optimistic case.

It is Jorgenson’s view that the optimistic case with productivity growth higher than that from 1990 to 2012 is most likely to occur. This more optimistic case is likely to occur both in Canada and Australia. In both cases it will occur because the end of the mining construction boom in Canada and Australia will mean that output is then rising faster than inputs. This means that productivity growth will be rising.

If Jorgenson is correct, and I think he is, then we have reason to be more optimistic about future growth in Australia than the consensus currently believes.


“Quantifying “Dog Days””, JM Dixon, PB Dixon, JA Giesecke and MT Rimmer, Centre of Policy Studies, Victoria University

“Australia and the growth of the world economy” by Dale W Jorgenson, Samuel W. Morris University Professor, Harvard University at the 24th Colin Clark Memorial Lecture, 8 July 2014

“Economics in Tasmania” Glenn Stevens, Governor, RBA, 3 July 2014

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