Making it last

Living off our resources

1 Comment 28 June 2010

How we frame policy choices — the conflict model

by Ian McAuley


Will an emissions trading scheme or a carbon tax harm our economy? What economic sacrifices must we make if we are to protect the Murray-Darling Basin?

Such presentations of policy choices, implying tradeoffs between social, environmental and economic objectives, are commonplace. Governments and corporations are urged to adopt “triple bottom line accounting”, reporting separately on social, environmental and economic performance. Government departments are structured around such classifications, with public policy (or campaign manifestos) emerging through compromises between conflicting social, environmental and economic objectives. The 2010-11 Budget, for example, with its tight fiscal discipline and its cutbacks for environmental programs, could be seen as a win for the economy and a loss for the environment.

However convenient as such classifications may be, they contribute to a way of thinking which can lead to poor policy, because realistically there is no such separation.

If economic policies do not contribute to the people’s welfare, what is their point? There will always be debate about whose welfare should have priority – children, working families, the aged – and about how we trade present costs and benefits for future costs and benefits. To suggest however that economic activity has some virtue in its own right is to seriously confuse means and ends. The notion of some trade-off between “social” and “economic” objectives makes no more sense than the (apocryphal) statement attributed to an officer in the Vietnam War: “we had to destroy the village in order to save it”.

Similarly, the notion of a trade-off between economic and environmental policy overlooks the nature of economic choices. Economics is concerned with how we use scarce resources. The scarcest resources of all are what we call “environmental” resources — our atmosphere, oceans, water, soils, and ecological systems.1

Unfortunately, the political conflicts over the Rudd Government’s proposed Emissions Trading Scheme (ETS) were about trade-offs: opposition to the ETS focused on its economic cost.

One can blame political opportunism or sloppy thinking in Opposition ranks, but the point is that the idea of a trade-off is so embedded in our thinking that the Rudd Government felt it was unable to turn the debate around.

We have become conditioned to thinking about economics in terms of a few simple indicators, the main ones being Gross Domestic Product (GDP), inflation, employment, interest rates and public debt, while ignoring other economic indicators such as poverty, ignoring what is not easily measured, such as human happiness or the state of environmental assets, and ignoring the great complexity of the way people interact with one another and with nature.

James Scott of Yale University calls this process “thin simplification”. The policy advisor seizes on a few simple indicators, forgetting that these indicators are mere abstractions incapable of capturing the complex reality of the systems to which they refer, and, in time, comes to see nothing else.2 The policy advisor, the politician, and the journalist believe that any policy which detracts from the performance of these indicators is poor policy. Simon Kuznets, who, 80 years ago, developed the conventions of national accounting that we still use today, warned that the welfare of a nation cannot be inferred from such measures. Today there are people like Joseph Stiglitz working on more inclusive indicators of economic progress, but in our policy development we are still locked into limited ways of thinking.

We have come to see our prosperity as a by-product of economic good fortune, and have come to believe that attending to environmental concerns is a luxury we can afford only if we put the economy first. Capturing this spirit, in moment of unguarded candour, referring to the Government’s proposed ETS, the Opposition Leader Tony Abbott said:

‘Basically this is a tax on the way we live because the way we live depends on energy, electricity, petrol – this is the ultimate lifestyle tax.’3

The reality is that we are living off our (and the planet’s) capital. We need a fundamentally different economic structure that will make best use of all our resources.

The lucky country — Greece with minerals

By the human development index, a UN indicator combining life expectancy, GDP per capita, education and living standards, Australia does well: out of 182 countries it is second only to Norway.4 Australia can also boast of being one of the very few OECD countries to have escaped a recession during the Global Financial Crisis (GFC).5

But is such economic performance sustainable?

Australia is an unusual country, once described as a third world country temporarily enjoying a first world living standard. Throughout our post-1788 history, there have been bouts of good fortune—the opportunity to supply world markets with wool, gold, beef, wheat and, for the past 40 years, coal, iron ore and other minerals. As we have depleted one resource, we have turned to another just as it has been needed by other countries. Donald Horne dubbed Australia as “The Lucky Country” in 1964, even before most Australians had heard about the Pilbara and when Roxby Downs was only an isolated and dusty cattle station.6 While most other prosperous countries have built their economies on efficient use of human capital, Australia’s prosperity, from the time the Macarthurs started exporting wool, has owed much to the exploitation of non-renewable resources. We have exported our resources with minimal processing, and have imported our needs from countries with more developed industrial structures.

To illustrate, Table 1, drawn from OECD data, shows exports of the products of high technology industries as a percentage of imports of those same products. Australia is near the bottom of the table, just above Turkey and Greece.

Table 1. Exports as a percentage of imports, high technology industries, 2008
Ireland 231
Switzerland 201
Korea 182
Sweden 126
Japan 125
Finland 123
Hungary 118
Germany 115
Denmark 110
France 109
Mexico 108
Netherlands 106
Belgium 102
Czech Republic 90
Austria 88
United Kingdom 84
United States 83
Slovak Republic 83
Iceland 77
Italy 72
Canada 62
Norway 49
Poland 49
Portugal 47
Luxembourg 45
Spain 44
New Zealand 27
Australia 25
Turkey 21
Greece 19

Source: OECD in Figures 2009, “High technology” defined as aerospace; office and computing equipment; drugs and medicines; radio, TV and communication equipment; medical, precision and optical instruments.

One indicator cannot paint a full picture, and to suggest that Australia is devoid of a high technology sector does an injustice to those few firms which have succeeded in world markets. Furthermore, it is unreasonable to paint our mining sector as purely extractive; in fact most modern mining operations involve complex technologies, and some mining firms have an element of downstream processing. Other indicators, such as patent activity, however, tell a similar story: Australia’s industrial structure is not that of a developed country. Greece is in trouble because it has been living beyond its means; we are yet to realise that we too are living beyond our means.

Of course, as became evident in the debate about a resource super profits tax, there is a view that because Australia has very large reserves of certain minerals, including coal, iron ore, copper and uranium, we can continue indefinitely with our current resource dependence.

Even if such resources are in abundant long-term supply, however, there are costs of such dependence. Those costs include economic volatility, a loss of control, and a lopsided economic structure.

Economic volatility arises because of the nature of world commodity markets. As the world goes through inevitable business cycles, and as some countries have rapid growth spurts as has been happening in China, prices of finished goods – eg, ships, cars, whitegoods and computers – fluctuate. The fluctuations in the prices of raw materials that go into these goods are much more marked, however. Figure 1 shows the wild ride taken by world metal prices over the past 25 years.


As the Australian currency has been more volatile than most other currencies (another consequence of commodity dependence), the Australian dollar prices of commodities have fluctuated even more widely. Figure 2 shows long-term prices of iron ore, in Australian and US terms.


Due to this commodity dependence, Australia’s economy is heavily reliant on the fortunes of the world economy. It used to be said that when America sneezes, Australia catches a severe cold. The same could now be said about our dependence on China’s health. Australia’s luck to date has been that as certain markets have matured, new ones have arisen, but there is no guarantee such luck will hold. Even if our luck holds, commodity dependence always results in exchange rate volatility. This means businesses in other trade-exposed industries, ranging from education to tourism, have fluctuating fortunes, making long-term planning and investment difficult. Individuals find their lives disrupted, having to move to find employment as regional economies rise and fall. Similarly demand for skills fluctuates, which means it becomes risky for people to become too specialised. The Reserve Bank finds that interest rates have to respond to international currency markets rather than to domestic conditions, with obvious consequences for house buyers and builders.

Another consequence, which became evident in 2010, is that commodity firms which have accumulated huge surpluses in the good times can use their financial reserves to exert political leverage. The whole economy can become hostage to a few firms.

Examples of extreme commodity dependence are provided by countries such as Saudi Arabia and Kuwait, where small numbers of people gain meaningful employment in the oil industry, while everyone else maintains material comfort through forms of welfare dependence. These countries struggle to develop the individual and investor incentives that apply in more developed countries. Their currencies rise to the level whereby non-resource industries have no hope of achieving international competitiveness; their economies become hollowed out. They cannot offer a range of employment to match the natural range of human skills. They do not have manufacturing sectors, where many people learn useful trades and skills. Australia has some similar problems, as identified in Treasury Secretary Ken Henry’s description of a “three speed economy” — a resource sector in the fast lane, a naturally-protected domestic service sector in the slow lane, and a trade-exposed sector in the breakdown lane.7

Just as labour markets become distorted, so too do capital markets. Investors in resource-intense sectors become conditioned to expect high returns. In economic terms, what is known as the opportunity cost of capital rises for the whole economy. Other sectors of the economy find it hard to get funding, because investors expect high returns. The consequence is generally an under-capitalised economy. Both public sector investors seeking funds for infrastructure and private sector investors seeking funds for industrial plant, where returns are more modest, are starved for funds. A consequence of such under-capitalisation is low labour productivity in that large part of the economy which is not directly linked to the resource sector.8

The well-respected development economist Jeffrey Sachs, Director of the Earth Institute at Columbia University, points out that being resource rich probably uses up one to two per cent per year of economic growth potential compared with being resource poor. [9. Sachs, J. (1996) Globalization and Employment Public Lecture to the ILO, Geneva.] The effects of resource dependence are pervasive; not only are there the exchange-rate effects (the “Dutch disease”) but also there are distortions in rewards and incentives.

The “economically pure” or neoliberal belief, however, is that we should let global economic forces play their part. If that means Australia’s economy becomes lopsided, with an overdeveloped resource sector while other sectors remain undeveloped, then just so long as income can be reasonably re-distributed so as to avoid social tension, then we should accept it: any interference in this process is inevitably at the expense of economic growth.

Encapsulated in this belief is the notion that society is subservient to an anonymous, inanimate market, driven by its own rules. Just as we must accept the laws of planetary motion, so too we must abide by the rules of the market.

This notion of market dominance, now entrenched in our way of thinking, is a modern phenomenon. Fearing an emergence of dysfunctional economic dogmas in the post-war period, in 1945 Karl Polanyi pointed out that markets have traditionally been embedded within societies, subject to society’s norms and rules. In other words, markets should serve social ends. Just as he feared the economic determinism of communism, so too did he anticipate and fear the rise of neoliberal philosophies which would place society as subservient to market forces.9 (He would have been only partially comforted by triple bottom line thinking, because it still fails to place markets within society.)

Polanyi’s thinking has no place in our brave new world, in which we are so conditioned to believe that any departure from pure market-based thinking is poor policy. Admittedly, mainstream economic thinking does acknowledge the limits of markets, with theories of externalities, natural monopolies, public goods and other market failures, but any extension of thinking to suggest that we should try to shape our national economies beyond that determined by the theory of Smith’s “invisible hand” is heresy. The greatest insult that can be made of an economist is that he or she advocates “picking winners”.

We do shape markets, however. We privilege the financial sector immensely, with measures such as compulsory superannuation and subsidies for private health insurance. We have privileged the resource sector with infrastructure and with low charges for extracting resources. We leave sectors of the economy, ranging from newspaper shops and taxis through to health professions, exempt from competition policy. We privilege housing with grants to owners and through maintaining a high level of immigration. By contrast we load labour-intensive industries with the burden of payroll tax. We do shape our economic structure, but not in a purposeful way.

There is a legitimate point that many of our past interventions to shape our economy have been ineffective, have led to unforeseen inefficiencies, and have created privilege for the few at the expense of many. For example, protective tariffs and quotas may have been appropriate instruments a hundred years ago, but by the time the Hawke Government was in office they had become serious impediments to our prosperity. Authorisation of retail price maintenance as a means of assisting retailing, imposed huge costs on consumers.

The fault with these interventions was not their intent, but their design. If we are to intervene in markets, we should do so in ways that do not impede innovation and which do not encourage monopoly profits. That means, where possible, harnessing the power of markets through using market-based instruments: for example, a tax on undesirable activities may be superior to a ban, because a tax sends a price signal, while a ban can spurn a black market. A measure which applies widely is superior to one which favours particular industries or firms; for example supporting general transport infrastructure or basic research is generally preferable to privileging railroads for a particular industry or supporting private research.

We can use our taxes and other public policy interventions to shape our economic destiny to ensure that we have a more resilient structure, so that we are not so buffeted by the commodity cycle.

The foregoing, of course, is based on a model in which we have plentiful resources. In reality, Australia is bumping up against resource constraints.

When luck runs out — policies for resource limits

Even if we have resource abundance, there is a strong case for shaping our economic structure towards a more balanced set of activities. If, as is now obvious, we have binding resource limits, the case is even stronger.

Through a combination of excess demand (aggravated by irresponsible pricing) and the early effects of global warming, we are facing severe water shortages. As stated by the International Panel on Climate Change ‘By 2030, water security problems are projected to intensify in southern and eastern Australia.’10 When we wrecked our soils through grazing sheep we were able to move on to other crops, but when we run out of water we won’t have anywhere else to turn.

More seriously, in terms of greenhouse gas emissions per capita, Australia is up there with the worst contributors, as shown in Table 2.11 The main culprit is coal, particularly brown coal.

Table 2. CO2 emissions, tonnes per capita
Luxembourg 22.35
United States 19.10
Australia 18.75
Canada 17.67
Finland 12.19
Czech Republic 11.83
Netherlands 11.13
Ireland 10.13
Korea 10.09
Belgium 9.97
Germany 9.71
Japan 9.68
Denmark 9.24
Greece 8.74
United Kingdom 8.60
New Zealand 8.48
Austria 8.38
Poland 7.99
Norway 7.85
Spain 7.68
Iceland 7.53
Italy 7.38
Slovak Republic 6.82
France 5.81
Switzerland 5.62
Hungary 5.36
Portugal 5.20
Sweden 5.05
Mexico 4.14
Turkey 3.59

Source: OECD in Figures 2009.

Greenhouse gas intensity is not an inevitable by-product of industrialisation, or of private transport. For example, Germany, which is much more industrialised than Australia and with similar high car ownership, has half our CO2 intensity per head and per unit of GDP.

If (or more rightly when) our energy resources are priced at a level which reflects their true cost – a cost which accounts for their environmental damage – we will realise their scarcity and be forced to adapt. That price may arise from a carbon tax or from a cap and trade scheme. Economists will say that it is sound economics, environmentalists will say that it is sound environmentalism; both are concerned with better allocation of scarce resources, and both agree that dirty energy producers should not be subsidised by exempting them from paying for their environmental externalities.

The notion that investments required to make the adaptation will hurt our economic growth does not stand up. If there has to be heavy investment in modernising our energy-intensive industries, then there may be a short-term diversion from consumption to investment, but it is better to make that small sacrifice early. For example, the longer we live with the illusion of cheap transport and domestic fuels, the more large houses we will build on our urban fringes. It is a cruel hoax on house owners to shield them from the unsustainability of our settlement patterns.

Modelling commissioned by the Australian Conservation Foundation and the Australian Council of Trade Unions, undertaken by the National Institute of Economic and Industry Research, shows that strong action to cut greenhouse gas pollution by 25 per cent will make households better off by 2030 than if we were to continue with “business as usual”, and, in the meantime, will have positive employment consequences.12 Farsighted industry leaders, such as Origin Energy Managing Director Grant King, has called for carbon pricing to remove the present relative price penalty applying to clean power.[14. Fraser. A (2010) “ETS collapse to boost coal-fired plants” The Australian 19 May 2010. Available online: http://www.theaustralian.com.au/news/nation/ets-collapse-to-boost-coal-fired-plants/story-e6frg6nf-1225868403280 ]

If Australia acts now we have an opportunity for an early start in new energy technologies, for which there will be world-wide demand. Australia’s expertise in mineral exploration and drilling, for example, should provide a head start in geothermal power development, but that opportunity will not be realised while clean energy has to subsidise dirty energy. We once had a world lead in solar technology, but we lost that when we failed to see its value.

One point, though, is that investment in new technologies and in new plants requires patient capital. The assets involved are long-lived but do not show spectacular early returns. Geothermal and wind power will require new transmission lines. Metropolitan subway systems require extensive tunnelling. Stormwater catchment requires re-design of our urban infrastructure. In contrast, incremental expansion of an existing coal fired power station, already privileged by having access to long-established transmission lines, shows earlier returns.

In that respect, we need to keep the cost of capital down, and to reform our investment taxes which, at present, reward short term speculation at the expense of long term investments.13 It is important, too that we come to accept more modest expectations about long term profits. As pointed out by Elroy Dimson and his colleagues at Princeton University, compared with other countries Australia enjoyed abnormally high investment returns over the 20th Century, thanks largely to commodity dependence.14 The hysterical reaction to the resource super profits tax confirms that Australian businesspeople, conditioned by a run of high profits, are living in a fantasy world of high and enduring investment returns.

Public policies towards sustainability

We need policies to re-structure our economy. Specific policies should be developed carefully, backed up by research and proper benefit-cost studies. In a document of this nature it would be premature to suggest, say, that we should have carbon quota of X tonnes (a carbon tax may be far better), or a specific depreciation allowance for renewable energy (it may be better to have different types of capital incentives).

It is possible, however, to articulate some general policy principles.

First, we should recognise the interaction of all policies. Compartmentalisation of policies leads to poor thinking and poor decisions, generally resulting in the elevation of a rarefied and abstract notion of “the economy”. We need to restore a “public service”, so that government employees do not confine their concerns to particular portfolios, and agencies do not see themselves in combative relationships.

Second, we should recognise that the purpose of economic policy is to serve society. This idea is hardly radical; it is to be found in mainstream economics texts. It does not emerge in public policy debates, however.

That may mean we sacrifice some headline growth (e.g. measured GDP) to ensure we live in a more harmonious society. It does not mean some utopian levelling, but it does mean that we restore equality of opportunity, for example through access to education and health care, and ensure that our economic incentives align with people’s contributions. As Wilkinson and Pickett point out, unfairness, and perceptions of unfairness, sap societies of their strength and resilience.[17. Wilkinson, R. and K. Pickett (2009) The spirit level: why greater equality makes societies stronger, Bloomsbury Press.]

Third, we need stop thinking of tradeoffs between “environmental” and “economic” policies. Environmental assessment should not sit alongside economic assessment: all consideration of allocation of scarce resources should be integrated. The externalities associated with consumption of environmental assets should be brought fully to account.

Fourth, we need policies which re-shape our economy to restore balance between resource extractive industries and other industries. That will generally be through harnessing the power of markets through prices, rather than through direct interventions (not the regulatory approach favoured by the present Coalition Opposition). Practical policy outcomes will include:

  • the full pricing of carbon and other greenhouse sources, full pricing of water and of other scarce resources;
  • the reform of taxation to remove penalties applying to long term patient investment, to remove the incentives for speculative investment in housing, and to encourage investment in human capital. The Henry Review has drawn attention to many distortions in our present arrangements, but much work is needed on means to achieve reform
  • the reform of the financial sector to shift investment funds from financial speculation to wealth creation. Reforms should aim to ensure the financial sector is the servant, not the master, of the real economy
  • adjustment assistance, where necessary, to firms and individuals, bearing in mind that if the government can hold a steady course on economic reform, there should be few surprises needing compensation. A carbon tax or auctioned permits will raise revenue to provide adjustment assistance, but there is no reason why all such revenue should be directed to adjustment assistance or compensation to households. For the most part firms and individuals should have time to adjust without needing assistance; and,
  • the provision of necessary public goods to allow re-shaping of the economy. Depletion of natural capital should be balanced by investment in public capital, including physical infrastructure in transport, water, and energy transmission, investment in research and human capital, and investment in public education. Such investment should be guided by rigorous and transparent benefit-cost analysis. Investment in education is necessary not only to provide the skills for an internationally competitive economy, but also to forestall opposition to change.

To clear the way for such policies, however, we need to dispel the myth that we are a developed country; living off natural assets has led us into complacency. We need to become a real developed country, earning our keep through our (renewable) human capital and entrepreneurship.

Such re-shaping involves a fundamental transformation of our economy, no less dramatic than the transformation that took place during the Hawke-Keating years. We have demonstrated that we can undertake economic transformation, and, although it will involve difficulty, the alternative path of stagnation, with a small extractive sector and a large low productivity sector, subject to the swings of world commodity prices, is not attractive to contemplate.

Photo Credit: Puddles, http://www.flickr.com/photos/48889075182@N01/4576455229/

Endnotes


  1. There will be some who hold the view that human values should not be applied to environmental resources – that there are legitimate interests beyond human interests. An anthropocentric view which has regard to option values and which applies a very low discount rate to long-term costs and benefits is unlikely to assign significantly different values to environmental resources than a more encompassing view.
  2. Scott, J.C (1998) Seeing Like a State: How Certain Schemes to Improve the Human Condition Have Failed, Yale University Press
  3. Lewis, S. (2009) “Emissions Trading Scheme killed by elevation of new Liberal leader Tony Abbott” Herald Sun December 2nd 2009. Available online: http://www.heraldsun.com.au/news/emissions-trading-scheme-killed-by-elevation-of-new-liberal-leader-tony-abbott/story-e6frf7jo-1225805923852
  4. UNDP (1999) Human Development Report Available online: http://hdr.undp.org
  5. Australia’s escape from recession was a stroke of definitional luck. By convention a “recession” is defined as two successive quarters of falling GDP. Australia had only one quarter of falling GDP; had that fall been averaged over two quarters, Australia would have been in recession. Also, because Australia has high population growth, there can be falling GDP per capita while there is rising GDP.
  6. Horne, D. (1964) The Lucky Country Penguin Books
  7. Henry, K. (2010) “Fiscal Policy and the Current Environment” Post‑Budget Address to the Australian Business Economists, 18 May 2010.
  8. Formally this phenomenon is described by the Stolper-Samuelson Theorem, originally applied to the economics of industry protection, and more recently by proponents of a resource rent tax. See Stolper, W.  and P. Samuelson (1941) “Protection and Real Wages,” Review of Economic Studies, 1.
  9. Polanyi, K. (1957) The Great Transformation: The Political and Economic Origins of Our Time 1945, Beacon Press edition.
  10. IPCC (2007) Climate Change 2007 Synthesis Report.
  11. The figures for Luxembourg are an artefact of energy reporting. Luxembourg has much lower gasoline taxes than its populous neighbours. Most of its emissions should be recorded against Germany, France and Belgium.
  12. ACF and ACTU (2010) Creating jobs – cutting pollution. Available online: www.acfonline.org.au
  13. ibid.
  14. Dimson, E, P. Marsh and M. Staunton (2002)  Triumph of the Optimists: 101 years of Global Investment Returns Princeton University Press.

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