E&OE
“In the eye of the economic storm: A new agenda for productivity and fiscal discipline”
[ACKNOWLEDGMENTS]
Warren Hogan
Professor Warren Hogan was a mentor to me and, as we all know, a huge influence in this department and this university for many years.
For better or for worse, I would not be here giving this lecture tonight if it were not for Warren Hogan.
I remember the debates that raged in his classes and seminars during my honours year.
Many will remember him for his teaching in public policy and international finance, for good reason.
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But he made his name in the late fifties in growth economics soon after the publication of the Solow growth model which is still central in contemporary economics textbooks.
He took on the big issues and the big names in leading Journals, including Nobel Laureate Robert Solow himself and Robert A Gordon (father of the well-known macroeconomist Robert J Gordon).
It was this background that made his public policy seminars for honours students so memorable.
He focused on the big issues.
Much of the discussion was about setting Australia up for an extended era of middle-class prosperity.
Throughout, he was always interested in strengthening the supply side of the economy.
Whether it was more flexible workplaces, more productive investment allocation or investment in human and intellectual capital through the universities, he instinctively understood that by getting the supply side right, prosperity would follow.
I remember so many of the debates in those seminars - they were a strong influence on my decision to continue to postgraduate economics at Oxford. Those debates continue to influence my views on important policy issues today.
Most of all, Warren was passionate about the intersection between rigorous economics, good public policy and growing prosperity.
And though he was clearly on one side of the debate over the teaching of economics at Sydney University, he was always open to a range of different views in his classes.
Defining the problem
The economic reforms of the 80s and 90s were a result of positions advocated by people like Warren Hogan.
Without doubt these reforms led to decades of prosperity for Australians - there was a consensus across political boundaries that change was necessary even if there was disagreement about some of the details.
Applying that thinking, to today’s challenges, brings me to the topic of today’s lecture, In the Eye of the Economic Storm: A New Agenda for Productivity and Fiscal Discipline.
There can be no question that after several decades of low inflation and strong economic growth, Australia today is facing a new economic storm, including:
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Persistent, above target inflation. For working Australians, the cost of living is up 18.2% in just over two years according to the ABS’ Employee Living Cost Index.
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Sclerotic growth - GDP per capita has gone backwards for six quarters while consumer and business confidence are entrenched at lows not seen outside of deep global recessions.
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An unprecedented collapse in living standards (almost 10% in just over two years) with no prospect of restoration any time soon.
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An economy where aspiration feels like a luxury good.
In response to this, Australians are working harder, saving less and cutting back on spending.
The traditional government response to an economic malaise is to stimulate demand.
Slowdowns are typically assumed to be cyclical, not structural.
But that is the wrong answer for today’s challenges.
Structural challenges on the supply side are now hurting us badly.
Restoring our living standards can only come from an expansion of the productivity capacity of the economy.
Ignoring this is like ignoring the laws of gravity.
Labour productivity has fallen 6.3% in just over two years.
This is in addition to the slow structural decline in total factor productivity growth across in developed countries that has rightly obsessed economists like Robert Gordon for a long time.1
While that structural challenge is important, the recent collapse in labour productivity is vastly different: We need 6.3% more labour to produce the same goods and services as in 2022.
It’s not surprising then that employment has been strong (which is obviously positive), but it has been at the expense of living standards.
How do we get out of the storm? I will outline three key parts to the solution.
First, a more realistic economic framework for understanding the world today.
Second, a portfolio of policies that can begin to put us back on track.
Third, honest and well-informed conversations about the challenges we face. 1 Gordon, Robert. The rise and fall of American growth: The US standard of living since the civil war. Princeton university press, 2017
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I call this a back-to-basics approach because while the application and focus of productivity reform of the 2020s will be different, the principles should be familiar to economists and policy makers. These principles reflect successful economic reforms of the past in a contemporary context.
We have done this before. It is in our muscle memory. And if we have courage in our leadership and our decisions, we can do it again.
A more realistic economic framework
Let me turn first to the need to begin with a more realistic economic framework for understanding the world today.
In recent years, it is clear that Keynesian demand side thinking has become dominant in policy circles.
New Keynesian models have proliferated across central banks and treasuries, and demand management has become a core economic tool for treasurers and finance ministers.
None of this is to say that these models haven’t made a contribution. They have. But like any model they reflect a particular focus.
The strength of New Keynesian models is in understanding economic fluctuations, not in predicting inflation or delivering structural growth in prosperity.
But some have taken this thinking much further.
At its extremes, a much more invidious variant has emerged in modern monetary theory - tempting policy makers with the promise of endless government spending without a cost.
A less extreme theory argues that if ‘g’ (economic growth) is greater than ‘r’ (interest rates on government debt) then Governments could endlessly and sustainably accumulate debt.2
Advised of these “fashionable” theories, some politicians, particularly from the left, couldn’t help themselves but to use them to justify their ambitions.
Let’s face it, you can always come up with an excuse for more government largesse and more government intervention if you are convinced that there are no costs. 2 For a balanced view of this position, see Blanchard, Olivier. "Public debt and low interest rates." American Economic Review 109.4 (2019): 1197-1229.
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Revisiting our benign inflation models
Given this context, perhaps we shouldn’t be surprised that central banks and treasuries alike underestimated inflationary pressures coming out of the pandemic.
The RBA raised expectations of no increase in interest rates until 2024 as part of its forward guidance.3
At the time of the last election, treasury was forecasting inflation to peak at 4.25% which was way off the mark.4
Just five months later, in the October 22 Budget, treasury again forecast a faster pathway back to the target inflation target band than we have seen.5
To be fair, we saw similar forecasting failures across the world even if Australia has been at the back of the pack in getting core inflation back to target.
How could the economics profession and policy advisers have got it so wrong?
The risk of persistent, high inflation hasn’t been a major focus of research for decades.
Indeed, the last wave of research in the 2010s was focused on below target inflation and the ‘zero lower bound’.
Some researchers argued that the Phillips curve was now flat,6 meaning that surges in government spending won’t trigger significant inflation.
The idea that inflation was largely immune to surging demand had become a feature of most economic models, including at central banks.7
Indeed Luci Ellis (former Assistant Governor of the RBA and the current Chief Economist at Westpac), has described this as a “dirty little secret of monetary policy”.
But our old enemy from the 70s and 80s had not gone away.
Inflation had just been in hiding, only to come back with a vengeance.
3 Lowe, Philip. "The Recovery, Investment and Monetary Policy." Speech, AFR Business Summit, Sydney, March 10, 2021. https://www.rba.gov.au/speeches/2021/sp-gov-2021-03-10.html.
4 Commonwealth of Australia. Pre-election Economic and Fiscal Outlook 2022, Table 2, 5. Canberra: The Treasury, April 2022.
5 Commonwealth of Australia. Budget Paper No. 1: Budget Strategy and Outlook 2022–23, Table 1.1, 6. Canberra: The Treasury, October 2022. 6 Hazell, Jonathon, et al. "The slope of the Phillips Curve: evidence from US states." The Quarterly Journal of Economics137.3 (2022): 1299-1344. 7 Luci Ellis Westpac Chief economist “We’re just not that special” July 19 2024 where she says “Most models of the Australian economy – including the RBA’s main whole-economy model– imply that if the policy rate is 100 basis points higher for a year or so, the peak effect of this on inflation is a reduction of a little less than 0.2 percentage points, about two years later”.
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We already have some good alternative frameworks for better understanding this surge in inflation.
First, John Cochrane and other advocates of the Fiscal Theory of the Price Level have consistently argued that traditional explanations for inflation are flawed8.
They make a strong case that fiscal policy is understated in the most widely used macro models and that ongoing structural deficits – as we see now in Australia - are inflationary.
Second, Gauti Eggertson and others9 have made a compelling case that when labour markets are tight (as they have been) the Phillips curve steepens dramatically10.
That means imbalances in supply and demand have strong inflationary impacts.
In simple terms, a sharp growth in government spending combined with supply shocks make for a deadly combination of inflationary pressures and constraints on economic growth.
Further work is needed particularly in the Australian context. Any economist wanting to do high impact policy focused research has a real opportunity here.
But the implications for policy makers are clear: we cannot underestimate the ongoing risks of inflation in this environment.
This provides new evidence for an old principle - that stimulating demand isn’t a free lunch in normal economic conditions.
Inflation is the price we pay for overstimulating the economy, bringing forward the long-term cost of debt accumulation, making it immediate to every Australian.
The imperative then is to contain the growth in federal and state government spending and fix the underlying structural budget deficit masked by short term commodity driven revenues.
We also need to be attentive to further supply shocks and the implications for inflation particularly in housing and energy markets.
8 Cochrane, John H. The Fiscal theory of the price level. Princeton University Press 2023.
9 Benigno, Pierpaolo, and Gauti B. Eggertsson. It’s baaack: The surge in inflation in the 2020s and the return of the non-linear phillips curve. No. w31197. National Bureau of Economic Research, 2023. Benigno, Pierpaolo, and Gauti B. Eggertsson. "Slanted-L Phillips Curve." AEA Papers and Proceedings. Vol. 114. 2014 Broadway, Suite 305, Nashville, TN 37203: American Economic Association, 2024.
10 Note there are competing explanations: Hazell, Jonathon, and Stephan Hobler. Do Deficits Cause Inflation? A High Frequency Narrative Approach. Technical report, 2024
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Continued sluggish labour productivity will heighten these risks as RBA Governor Michelle Bullock has acknowledged. 11
A platform for longer term low inflation growth
Alongside the shorter-term imperative to bring inflation back to target and restore our standard of living we also need a longer-term platform for strong, low inflation growth.
That’s how Australians are able to earn more or better balance their lifestyles.
That’s how we build more competitive businesses and that’s how we fund the essential services and defence force we need in our modern, geopolitical environment.
Too many initiatives are implemented without regard for unintended supply side consequences.
As Professor Hogan consistently emphasised, the power of good economic thinking is that it surfaces unintended consequences.
Price caps curb supply and therefore drive up price pressures.
Heavy handed regulations intended to protect consumers add costs, reduce market access and can therefore hurt customers.
Government subsidies intended to improve household budgets can add to inflationary pressures and worsen the situation.
Sadly, too many initiatives are implemented without regard for unintended supply side consequences.
Historically the closest thing to a sustainable free lunch in economics is on the supply side, through productivity gains.
The McKinsey Global Institute has highlighted that productivity is essential to solve the debt, inflation, energy, and skills shortage challenges confronting most advanced economies.12
Australia is no exception. Economic modelling from the Business Council of Australia has shown that were our productivity performance to increase to 1.7% - still below our best performance - we could see:
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The Budget comfortably in surplus with debt being paid down
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250,000 more Australians employed
11 Bullock, Michele. "Media Conference: Interest Rate Decision." Reserve Bank of Australia, August 6, 2024. https://www.rba.gov.au/speeches/2024/mc-gov-2024-08-06.html.
12Atkins, Charles, Olivia White, Asutosh Padhi, Kweilin Ellingrud, Anu Madgavkar, and Michael Neary. Rekindling US Productivity for a New Era. McKinsey Global Institute, February 2023.
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Rising tax revenue without increasing tax rates; and
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Higher incomes per person, without workplace relations overreach.13
The opportunity here is tremendous. Not just to drive real wages growth but to bring down inflation and build a dynamic and resilient economy.
Getting it right will underpin the economic miracle which is our modern economy.
The consequences of getting it wrong will burden our future generations as much as the current one.
Indeed the latest Intergenerational Report paints a bleak picture of higher taxes, higher spending, structural deficits and sluggish growth in real incomes for the next 40 years.
Non-market services and highly regulated market services
Central to enabling longer term productivity and growth is recognising the challenges of non-market services (especially the so-called ‘care economy’) and highly regulated market sectors like financial services.
As Australia has become wealthier, we have become more attuned to unexpected life events that undermine our standard of living.
Whether it is chronic health conditions, job loss or loss of a partner, Australians want to know that they are insulated against the worst life can throw at them.
We recognise that no modern government can suggest that Australians should go unprotected against these risks.
But it is also true that rapid growth in public spending is crowding out private sector activity and investment at a time when the supply side of our economy is constrained.
The majority of employment growth is coming from the non-market sector,14 where there is direct public employment or jobs indirectly funded by governments, while market sectors are experiencing skills shortages.
13 Business Council of Australia. Seize the Moment: A Plan to Secure Australia’s Economic Future. August 2023. Accessed October 2023. https://www.bca.com.au/seize_the_moment. Pg 45.
14 Ottley, Harry. Economic Insights: Global Economic & Markets Research. Commonwealth Bank of Australia, July 2024. Accessed October 2023. https://www.research.commbank.com.au.
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This challenge runs beyond fiscal cost. Productivity in the market sector has outstripped the non-market sector by 17.5% since 2000.1516 e-61 Institute research has shown that:
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There has been no labour productivity growth in the care economy for 20 years, reducing economy wide productivity by 0.2 per cent each year.
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Growth in the care economy is driving skill shortages in market sectors.17
Without productivity gains across the economy, we are on pathway to higher taxes or less essential services, which Australians will also reject.
Where To Start: getting back to basics to get us back on track
All of this means that we need an agenda focused on getting the basics right.
We have sought to kickstart this debate from Opposition around five key areas:
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Fiscal rules and spending reform
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Regulatory reform
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Energy policy
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Housing policy
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Tax reform
The first area of focus: Fiscal rules and spending reform Government spending is at its highest level on record according to the Final Budget Outcome from last year, and the structural deficit is only heading in one direction.18
What was supposed to be temporary response to COVID, has since become structural.
It is clear this is not sustainable, risks further inflation and reduces headroom for future shocks.
Australia must at a minimum return to the clear fiscal guardrails established by Peter Costello in 1996 and that remained a hallmark of our fiscal strategy until October 2022.
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Introducing a tax to GDP cap
15 This productivity malaise in non-market services is in line with the so called Baumol effect laid out in Baumol, William J., and William G. Bowen. "On the performing arts: The anatomy of their economic problems." The American economic review 55.1/2 (1965): 495-502.
16 Read, Michael. "Government-funded Jobs Are Booming, but We’re Not Getting Bang for Buck." Australian Financial Review, September 9, 2024. Accessed October 2024. https://www.afr.com/policy/economy/government-funded-jobs-are-booming-bu....
17 Maltman, Matthew, and Ewan Rankin. What If We Didn't Care? Implications of Growth in the Care Economy for the Broader Macroeconomy. e61 Institute, October 2024.
18 Commonwealth of Australia. Final Budget Outcome 2022–23. Canberra: The Treasury, September 2023. Accessed October 2023. https://www.budget.gov.au.
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Limiting real spending growth to less than economic growth
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Targeting a structural budget balance over the medium term
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Ensuring Australia is positioned to respond to future shocks
These disciplines are not just important for treasurers, but they act as a constraint on ministerial colleagues and the public service.
I saw the power of this from 2013 until the pandemic – where the Coalition brought the budget to balance, enabling our response to the COVID crisis.
The OECD and IMF have been consistent in their calls for stronger fiscal safeguards.
Unprecedented for an opposition, we have already identified over $92 billion of spending that we have opposed in the parliament.
We have extended the olive branch to work with the government to start putting the care economy on a more sustainable trajectory – through reforms to the NDIS and Aged Care.
This is not about austerity today, but it is how we avoid the need for austerity tomorrow.
The second area of focus must be regulatory reform
Australia has hit a point where company directors spend more time on compliance than on strategy and investment.
This is leading to a decline in public equity and debt markets and a sharp rise in private equity and credit.
While growth in private equity and credit is positive for competition and dynamism, it shouldn’t be on the back of public market decline.
Independent research has put the cost of red tape to the economy at $176 billion a year, with the volume of regulatory restrictions in federal law at its highest level in recorded history.19
Business Council of Australia analysis showed that in 2022 alone, there were 120,000 clauses regulating behaviour and changing incentives in Commonwealth legislative instruments.20
Regulation starts with good intent – but when every problem is looked at in isolation, an intervention is always a solution.
19 Clark, Lachlan, and Saxon Davidson. The Growth of Red Tape: Causes and Solutions. Institute of Public Affairs, November 2023.
20 Business Council of Australia. Seize the Moment: A Plan to Secure Australia’s Economic Future. August 2023. Accessed October 2023. https://www.bca.com.au/seize_the_moment. Pg 35.
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The broader impacts and unintended consequences are ignored.
The financial services sector offers an alarming case study.
Nobody will defend the action of predatory financial advisers, or sub-prime lending.
Yet we have put in place regulatory rules that have seen the number of financial advisers half over a decade; while Australians are increasingly unable to find a home; and small business lending as a proportion of the banks loan books has collapsed.
We run the risk of becoming under-banked, under-insured, and under-advised at a time our aging population will demand more financial services, not less.21
The Coalition has called for more fit for purpose regulation of our financial markets.
This starts with the establishment of a Financial Services Regulatory Grid, an initiative the government has adopted.
But it needs to be a beachhead for further reforms, including a strong focus on competition policy. That means:
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Delivering the Quality of Advice Review;
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Providing a framework for digital assets; and
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Progressing open banking through the Consumer Data Right;
Beyond financial services we need sensible reforms to unwind productivity draining regulations in climate reporting, environmental approvals, the corporations act and workplace relations.
This red tape reallocates resources from positive economic activity to onerous box ticking.
With workplace relations, for example, we need to re-establish the primacy of employers and employees working together to deliver higher real wages alongside more competitive workplaces.
The third area of focus is energy policy
Abundant, affordable energy has been the backbone of Australia’s economic success.
As a former Minister for Industry, Energy, and Emissions reduction, my number one task was to keep prices down as we brought emissions down.
It required tough decisions, strong competition policy, and a relentless focus on supply.
21 For instance, Thompson, James. “Why Shayne Elliott says its time to tweak responsible leading rules.” Australian Financial Review, April 24, 2024.
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I learnt in that role that there is no social license for higher energy prices.
This is a crucial factor when we consider the challenges of energy security and climate change.
The energy debate needs to progress from idealism to reality.
We need to secure affordable, reliable energy while taking steps to reduce emissions.
This means embracing every technology that can play a role – and remembering there are many roles to play in our diverse energy system.
As our economy grows – we will need more energy, not less.
AI and quantum require vast amounts of reliable energy and these technologies will be central to stronger productivity outcomes in the coming decades. You cannot power data centres on rhetoric.
This is why the Coalition has opened the debate about removing regulatory barriers and investing to support a nuclear industry.
With a third of the world’s uranium, some of the world’s leading nuclear researchers and regulators, and the global project management expertise – this is a field where Australia has the potential for true comparative advantage.
We will also ensure we put in place the policy settings to unlock more gas supply alongside growth in renewables.
This is essential to securing our manufacturing base – but also keeping power bills low in the medium term.
Renewables, gas, nuclear and carbon capture and storage will all be part of the energy mix.
The fourth area of focus is housing policy The great Australian dream of home ownership is integral to our national character and the aspirational drive that fuels our economy.
Locking Australians out of home ownership is not just morally wrong but economically reckless.
With 50% of small business lending secured against the family home, it is also a threat to our entrepreneurial culture.
Review after review – from the Henry Tax Review, the Retirement Income Review – has identified that home ownership is the primary determinant of quality of life in retirement.
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A collapse in home ownership has profound implications not just for our aspirational character, but the costs of our retirement system.
The challenge is complex and there is no silver bullet. It requires every lever to be pulled and three in particularly.
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Security: By making it easier for Australians to secure a home. The Coalition has started by aligning superannuation with other global retirement schemes - like 401k - that allow withdrawals for the purpose of purchasing a first home
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Serviceability: Making it easier for Australians to afford to retain their homes. The starting point is managing budgets and fiscal policy to put downward pressure on interest rates and inflation.
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Supply: Ensuring we are building enough homes and that population growth aligns with housing supply.
Of all the challenges – this is the most important to get right.
The fifth area of focus is tax reform
True tax reform must focus on growing the pie - by incentivising investment and driving productivity in both the private and public sectors.
Too often, the default assumption in tax reform is to simply increase taxes.
We need to remember the source of our prosperity, laid bare in the ATO tax statistics:
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Our resources industry: $36 billion in tax
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Our financial services industry: $37 billion in tax.
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Our professional services: $29 billion in tax
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Our manufacturing industry: $25 billion in tax
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Our construction and retail both contribute: $18 billion in tax22
This is the golden goose that funds our roads, our schools, our universities, and our hospitals.
A strong private sector is essential to securing the essential services Australians deserve.
The Coalition’s starting point is focused on tax reform that enhances incentives and boosts investment.
Our guiding principles are that taxes should be lower, simpler, and fairer.
22Australian Taxation Office. "Snapshot: Taxation Statistics 2021–22." Accessed October 2024. https://www.ato.gov.au/about-ato/research-and-statistics/in-detail/taxat....
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Lower taxes – means we will strive to reduce the income tax burden on families and young Australians by ensuring government lives within its means.
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Simpler taxes – goes not just to tax design, but the complexity of the overall system. How tax is collected, and how Australians interact with the ATO.
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Fairer taxes – means giving small business a fair go, and ensuring we make multinationals and large companies pay their fair share of tax.
As a first priority, a Coalition tax policy prioritises delivering for families and small business, and driving sector neutral investment settings.
Our commitment to make the Instant Asset Write Off permanent is a downpayment on this priority.
This is a structural change to our company tax system that will simplify depreciation for 2.5 million small businesses. It is a major commitment, that will reward 98% of Australian businesses when they choose to invest to grow their businesses and grow the economy.
We have opposed poorly designed tax changes to introduce taxes on unrealised capital gains into our tax system.
Our path forward will focus on creating an environment that rewards effort, encourages investment, and makes the system work for all Australians—families, businesses, and the broader economy.
The Conversations Required for Future Prosperity
The politics of productivity and sensible reform are challenging. It takes time. But it can be done. And it must be done.
We have a generation of leaders trained to believe that productivity is a bad word.
Many have also come to believe that any problem can be fixed with an announceable.
Usually that’s a big spending program or a major government review or intervention.
This bias has accelerated the loss of trust between hardworking Australians and their leaders – in government and politics, in business, thought leaders in the academy and even leaders in civil society.
To address this, we do need a high-quality debate. Economists, academics, and policy makers all need to be part of that.
Australians are more open to a conversation about what is needed than at any time in my political career.
Australian families and households know only too well that things aren’t working.
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They feel it every day:
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At the checkout.
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When they get their energy bill.
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As they clock in for their second job.
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When they get declined for a mortgage.
As the current household recession extends beyond 18 months, I have no doubt there will be continued calls for big spending initiatives to stimulate growth.
We need to be clear about the implications of doubling down on stimulating demand at a time of supply side constraints and higher interest rates.
We need to be vigilant about the risks of triggering further inflation.
And we need to be clear that productivity is the key to the prosperity, the opportunities and the essential services that Australians want. It is what makes your job easier and makes it easier to run a business.
History is riddled with examples of countries endowed with similar starting points winding up with vastly different economic outcomes. Acemoglu, Johnson and Robinson just deservedly won the Nobel Prize for work in this area.23
We stand at a crossroad like we did over forty years ago.
Down one path lies greater government control, more regulation and higher taxes.
Down the other, a future fuelled by private innovation, economic freedom, effective government services and a healthy low inflation economy.
In the spirit of Warren Hogan, we need to embrace these hard debates and pursue the research that will inform them.
That’s how we can all shape a better future for our great nation.
Thank you.
ENDS. 23 Acemoglu, Daron, Simon Johnson, and James A. Robinson. "The colonial origins of comparative development: An empirical investigation." American economic review 91.5 (2001): 1369-1401