Eslake ponders a productivity pickle

Saul Eslake was one of the first economists to sound the alarm bell on Australia's deteriorating performance on the productivity front. Now chief economist at Bank of America Merrill Lynch, he talks to Business Spectator about the growing awareness on the part of Australian companies that they need to boost productivity levels, even though our political leaders are shying away from reforms.

First of all, Saul, we are finally seeing a greater recognition that Australia needs to lift its productivity.

Yes, until a few years ago the general view was that the deterioration in Australia's productivity performance was largely the result of peculiar things that were happening in the utilities and mining sectors, which were in turn easily explained away. Hence there was a fairly complacent attitude that we didn't have much to worry about.

Now, however, productivity is right back on the agenda. I should add that this is not because we're on the cusp of a fresh wave of productivity-enhancing reforms, or because politicians are looking to revise any of the productivity-stifling legislation and regulation that they have enacted in the pursuit of agendas such as increasing 'security' or enhancing corporate governance standards – which they've done without any assessment of the probabilities associated with the risks they're supposedly seeking to reduce, or the costs versus the benefits of what they've sought to do.

However, I do think that there is a reasonable basis for thinking that many firms, of their own volition, are now beginning to look for ways to improve productivity in their own operations. Over the last six to 12 months, business leaders who have for some time been facing major structural headwinds in the form of the strong Australian dollar, and the changed patterns of household spending and borrowing, have begun to accept that these are lasting, rather than ephemeral things. As a result, in order to cope and to ensure the future viability of their businesses, managers in these firms are looking for productivity gains in a way that they haven't done for a decade.

The Reserve Bank is now clearly signalling that Australia's interest rates may have to rise unless we see start seeing some productivity gains.

Yes, but I think they might be underestimating the effect that the search for productivity gains is going to have on the employment and unemployment levels in aggregate. I say this most respectfully, because the Reserve Bank undertakes an enormous amount of ongoing liaison with business, far more than I'm in a position to do.

The Reserve Bank is saying that we need to see productivity improvements in the non-traded services sector because inflation in that sector needs to be brought down. The Reserve is also saying this can happen without unemployment rising above 5.5 per cent. I'm not persuaded by this argument.

I should add that in the last few sets of national accounts we've seen tentative indications that productivity growth maybe starting to turn around (although we have to be wary about drawing conclusions from short-run data that is very flawed). The measure of labour productivity in the quarterly accounts – gross value added per hour worked in the market sector – had been showing negative annual growth during 2010-11. But it improved by 1.8 per cent in the year to the December quarter. So, although we need to be wary of drawing conclusions from short-term movements, at least we're heading in the right direction.

What pressure is there on Australia's services sector to boost productivity?

There is considerable pressure. Take the financial services sector, for instance. The banks and other financial services firms came through the financial crisis relatively unscathed. And they subsequently started 'bulking up' employment in the expectation that the days of double-digit credit growth would come back – and they haven't.

So financial services firms are now realising that the volume growth they'd been banking on isn't going to be there. At the same time, many are facing higher funding costs that they can't fully recoup from their customers. As a result, they're looking to cut their second-largest cost – their labour force – in order to maintain their profit margins. Most of the major banks have now announced they're reducing their staff numbers, and even the insurer IAG has said it's doing the same. So it's not just banks.

The retail sector is also largely in the non-traded services sector, although the rise of internet shopping means that they're trade-exposed to a certain extent.

Retailers have been bewailing the lack of growth for two or three years now, but the level of employment in the retail sector has remained remarkably constant.

Other sectors – such as manufacturing and tourism – are also likely to push for productivity gains. But employment in those sectors has remained resilient even though businesses in those sectors say that demand is very poor.

So firms in those sectors had been waiting for the good days to return?

They had been. One of these characteristics of businesses in the 'real' economy (which distinguishes them from financial market participants) is that they tend to change their minds less frequently and more slowly about the climate they're operating in.

People running businesses saw that the financial crisis hadn't changed much, and there was a pretty common view that the stronger dollar was a passing phase, and that it would soon head lower. In the retail sector, businesses saw the rise of internet shopping as linked to the stronger exchange rate, and took the view that it wasn't going to last. In the banking sector, people thought it was only a matter of time before lending picked up sharply.

But over the last six to 12 months, managements are increasingly taking the view that what they thought were short-term things are actually long-term changes that demand a response.

How flexible is the Australian workforce now?

It's a lot more flexible than it used to be. Managers of firms have far more scope to adjust labour inputs – through changing hours and reassigning tasks – than before the labour market reforms started by Laurie Brereton and continued by Peter Reith in the 1990s.

There is, to be sure, a growing body of anecdotal evidence that the changes to the industrial relations framework have reduced that flexibility a bit (although there is as yet no statistical proof of those assertions).

There are some signs that unions are seeking to use some of the elements of the new industrial relations framework to interpose themselves into decisions – such as hiring and firing – that management has decided for the past 15 years. As a result, it has perhaps become harder for firms to achieve productivity growth.

However, where employers have gone all the way – such as Qantas and the Victorian government with the nurses – the Fair Work Tribunal has found in their favour.

How committed are Australia's politicians to achieving productivity reforms?

In the 1980s and 1990s we saw a growing awareness among the leadership of both major political parties, and also on the part of the general population, that things needed to change.

By the early 1990s we'd had two decades of high inflation and unemployment, our terms of trade had been declining since the mid-70s, and our living standards were deteriorating compared to other countries. It was an environment in which it was possible for political leaders to push through changes.

It's a stark contrast to today. We haven't had a recession for 20 years, our living standards have been rising steadily (relative to other countries), the terms of trade are high, and we're in the midst of the biggest mining boom in 140 years.

As a result, the public isn't persuaded of the need for change. What's more, they've also noticed that the benefits of past reforms have gone to a narrow sector of the population. And we don't have political leaders who are either persuaded of the need for reforms, or who have the political skills to make them happen.

I have no great expectation that if we had a change of government I'd be saying anything different. The Coalition is not saying, ‘vote for us because we will deliver wide-ranging, productivity-enhancing economic reforms', they're saying ‘vote for us and taxes will fall, benefits will rise and the deficit will be lower'.

Finally, Saul, what about improving public sector productivity?

One of the problems in this area is the widespread belief that there is a positive correlation between the number of people employed in delivering a public service and its quality.

So, for instance, people believe that smaller class sizes lead to better student outcomes, even though my former colleague Ben Jensen at the Grattan Institute (among many others) has shown that even though there's been a huge increase in spending per pupil and a reduction in class sizes, Australia's student performance has deteriorated over the past decade. Ben's work shows that student outcomes are lifted by better teaching rather than by smaller class sizes.

Now, education is a major sector of the economy in its own right, and it's also an important 'enabler' for other sectors of the economy.

It's interesting that in Victoria, the Baillieu government is looking to cut the public service by 10 per cent, even though it has a wafer-thin majority. In contrast, in New South Wales, the O'Farrell government, which enjoys an impregnable majority that guarantees it at least two terms, is less inclined to go down that path.