Prioritising Policies for Prosperity
By Tony Makin
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Since the mid-1980s, we have been led to believe that increasing national saving is central to improving economic performance and long run living standards. More saving by resident households is thought to reduce the economyÕs reliance on foreign saving and allow greater capital accumulation and hence greater aggregate production and income. Raising national saving, a major objective of a series of recent federal budgets, has therefore been a high economic policy priority.Ê This priority has also been influenced by the fact that AustraliaÕs gross domestic saving as a proportion of GDP has fallen significantly over recent decades from some 25 per cent of GDP in the mid-1970s to under 20 per cent in the 1990s.1 ÊÊ

Meanwhile, AustraliaÕs multi-factor productivity growth, as now regularly measured by the Australian Bureau of Statistics, has risen sharply in the 1990s relative to the past and to many other economies reflecting a dividend from the microeconomic reform program that began in the mid-1980s. The annual average rate of productivity growth in the 1990s has doubled to around 2.4 per cent from its previous long-term average.Ê This has enabled the Australian economy to grow at rates above the post 1950 average without generating inflationary pressures.Ê In general, however, trends in multi-factor productivity growth have unfortunately received much less attention than trends in saving over recent decades.

Both domestic saving and productivity performance can potentially contribute to economic growth.Ê Yet their respective impacts vary according to any particular economyÕs level of development.Ê A question therefore arises as to which source of growth should be given the higher policy priorityøincreasing national saving or improving productivity?Ê This paper suggests that in AustraliaÕs case, productivity improvement is likely to be more effective in raising the rate of economic growth than policies aimed at lifting domestic saving.

In summary, this is because the economy already has a relatively large capital stock in existence and because foreign saving also provides a readily available supplement to domestic saving to fund its additional investment needs. Accordingly, microeconomic reform measures aimed at sustaining multi-factor productivity growth warrant a higher policy priority as a means of achieving higher growth than attempts to raise national saving.Ê To assist in this regard, the microeconomic reform agenda could be motivated by a prescribed target rate of multi-factor productivity growth of, say, a minimum of two per cent over the business cycle.

Figure 1: Annual Domestic Saving as Percent of Capital Stock

Sustaining higher growth: More saving or more reform?

Consistent with the straightforward analysis outlined in Box 1, improving the economyÕs productivity is clearly a preferable policy alternative for an advanced economy on several grounds.Ê First, raising saving in relatively low saving economies like Australia implies some sacrifice in terms of foregone consumption by its residents. To the extent that an economyÕs consumption is indicative of the overall level of economic welfare, achieving higher saving may imply a greater economic welfare cost than implementing measures that boost multi-factor productivity.Ê

Second, the magnitude of net saving in advanced economiesøan annual flow measureøis in reality only likely to be a tiny fraction of the value of the existing capital stock. For instance, the actual ratio of AustraliaÕs net saving to its net capital stock over recent decades is shown in Figure 1.Ê A doubling or even trebling of the existing annual rate of domestic saving would still yield an annual increase in the capital stock that remained small in relation to the size of the existing capital stock.Ê This is because the capital stock in use has been accumulated over a very long time span by virtue of all past saving.Ê Indeed, part of the capital stock currently in productive use, such as buildings and basic infrastructure, could of course have resulted from saving undertaken over a century or more ago.Ê On the other hand, developing economies almost by definition have low capital per worker ratios. This makes saving and the accumulation of new capital that much more important.

Third, if increasing domestic saving becomes the main policy focus, national output increases would then mainly stem from new additional investment projects that may take some time to identify and complete.Ê Yet, policy initiatives that improve the use of the entire existing capital stock, in practice as shown in Figure 1 a very large multiple of any annual addition to it through net investment, can have a more immediate positive effect on national production.

Figure 2: Domestic and Foreign Saving (as percent of GDP)

Fourth, foreign saving provides an alternative to domestic saving as a source of financing domestic investment. In other words, financial globalisation has greatly improved economiesÕ access to foreign funds which can supplement domestic saving as a means of financing domestic investment.Ê Figure 2 illustrates the extent to which foreign saving has been used relative to domestic saving to fund AustraliaÕs investment requirements over recent decades.Ê

Provided the rate of return on foreign-funded domestic investment exceeds the servicing costs of the external borrowing, foreign saving contributes positively to economic growth for it allows domestic capital accumulation to be higher than it would be through reliance on domestic saving alone.Ê There is now a large literature on the gains from international trade in saving, the precepts of which have provided the International Monetary Fund with a rationale for prescribing capital account liberalisation for many countries.

Fifth, another problem associated with the excessive policy focus on domestic saving is that conventional saving measures are distorted by some measurement problems.Ê For instance, domestic saving is understated to the extent that, by national accounting convention, public expenditure on education and health is treated as consumption.Ê Yet such spending may alternatively be perceived as investment in human capital and, if accordingly re-classified as such in the national accounts, would yield higher estimated values of national saving.

The current practice of treating government expenditure on human capital as public consumption causes problems when making international comparisons of conventional saving measures.Ê In particular, because governments in advanced economies such as Australia, Canada, the United States and New Zealand spend heavily on items such as education and health, the measured saving of these economies therefore tends to appear lower than for other economies which spend relatively less in these areas.

How and why productivity has improvedÊ

AustraliaÕs productivity has improved markedly in the 1990s relative to past trends and this has enabled the economy to grow at rates above the post 1950 average, without generating inflationary pressures.Ê Productivity growth had previously lagged international standards, recording a long-term historical average of only 1.2 per cent from the mid-1960s until the early 1990s, but since the early 1990s has risen to an average annual rate of 2.4 per cent.2 The overall productivity improvement has been due to a turnaround in capital productivity reflecting far more efficient use of the capital stock.

Generally speaking, this productivity improvement is a result of technological advance and numerous other policy-related influences that have increased the degree of competition faced by domestic firms, reduced business uncertainty, raised the quality of human capital and improved the allocation and use of resources.Ê In turn, many of these influences have resulted directly from reform efforts at federal and state levels that have effectively raised the speed limit on AustraliaÕs growth above the average three per cent experienced over the second half of this century.

Misdirected microeconomic and macroeconomic policy priorities in the past explain why AustraliaÕs productivity growth was previously so poor.Ê At the microeconomic level, these earlier policy priorities included high levels of government regulation and extensive public ownership and control of enterprises across a range of industries, such as transport, communications, electricity and water.Ê At the economy-wide level, there were also high levels of protection against imports, restrictions on foreign investment and international capital flows, a highly centralised wages and industrial relations system, high budget deficits and inflation at rates persistently above AustraliaÕs major trading partners.Ê

Since the beginning of the 1980s, economic nationalist and na•ve Keynesian-inspired policies have been reversed.Ê Policy initiatives have lowered tariffs, liberalised financial markets and foreign investment, privatised and commercialised public enterprises, and delivered more flexible labour markets and reduced business regulation in some areas. On the macroeconomic front, the most notable causes of improved productivity have been increased internationalisation of the economy, a shift to a lower inflation regime, greater fiscal responsibility, labour market reform and more extensive education and training of the workforce.Ê Substantially increased flows of exports, imports and foreign investment reflect a faster rate of internationalisation of the Australian economy that began in the 1980s and has continued through the 1990s.

This internationalisation process itself has been driven by two fundamental productivity-related causesøimprovements in technology and the domestic and international liberalisation of markets for goods, services and investment.Ê Tariff reductions have increased competitive pressures on local producers, while direct foreign investment has introduced new products and processes and facilitated the international transfer of management expertise.

An important monetary influence on the business environment in Australia was a sudden shift in the inflation regime in the 1990s from previous decades.Ê Inflation was relatively high and variable by OECD standards throughout the 1970s and 1980s, but fell sharply from an 8 per cent decade average in the 1980s to around 2 per cent on average in the 1990s.Ê Previously, ever-changing inflation expectations had distorted the structure of interest rates and adversely affected borrowing and lending decisions, as well as increasing investment and exchange rate uncertainty.Ê

Figure 3: Multi-factor Productivity Growth

Widespread financial deregulation throughout the 1980s has also removed many distortions that had previously prevented funds flowing to their most productive use.Ê Average federal budget deficits and public debt levels have been relatively lower in the 1990s compared to 1970s and 1980s with implications for inflation expectations and real interest rates.Ê Apart from minimising the size and frequency of budget deficits, there has also been considerable privatisation of public sector assets and the corporatisation of public utilities at the state and federal levels.

The improvement in productivity in the 1990s has also coincided with an increase in labour market flexibility and an historic move away from a previously highly centralised system of wage determination.Ê In earlier decades, the terms and conditions of workers in many industries were set through a more centralised process involving tripartite participation by trade unions, employers and governments at federal and state levels.Ê However, the system that has evolved more recently allows greater scope for bargaining at the enterprise level.Ê

There has also been a strong increase in higher education participation in the 1990s, as well as more extensive vocational training, both of which have created a better skilled workforce attuned to the needs of domestic industry. Participation rates in higher (post secondary) education, for instance, have risen from a rate of 37 per 1000 in 1987 to 50 per 1000 in 1997 in the working age group 17-64 and even more dramatically in the 17-24 age group from 102 per 1000 to 165 per 1000 (Australian Department of Employment, Education and Training 1997-98).

Conclusion

The apparent decline in AustraliaÕs national saving over recent decades has not been a uniquely Australian phenomenon.Ê Indeed, AustraliaÕs supposed low saving rate remains broadly comparable to the saving rates of numerous other OECD economies, including the United States (whose saving has actually been slightly below AustraliaÕs ever since the 1960s), Britain, Canada and New Zealand.Ê Only JapanÕs saving rate has significantly exceeded those of all advanced economies.

The performance of the worldÕs two largest economies, the United States and Japan, suggests a paradox about the role of saving as the primary source of economic growth.Ê The puzzle is that the United States economy has shown remarkable strength throughout the 1990s despite recording one of the lowest saving rates, while Japan with one of the highest saving rates has experienced prolonged macroeconomic stagnation over the same period.3Ê How can this be if domestic saving is supposed to be so central to the growth process?

The apparent paradox that the United States as a low saving economy has been far more robust than high saving Japan over the past decade is easily resolvable once domestic saving is recognised as but one source of economic growth, of less importance in advanced economies than productivity enhancing factors.Ê In short, productivity growth is the key determinant of the standard of living because it reflects the efficiency of the use of the entire capital stock.Ê Of course, this may not necessarily be true in developing economies where higher saving may be more important if a severe shortage of capital is the main obstacle to further development.

The Australian policy emphasis on domestic saving suggests that saving has been playing the role of a quasi-intermediate target for raising the rate of sustainable economic growth.Ê However, instead of trying to raise domestic saving there could be a separate and explicit focus on targeting multi-productivity growth, as measured by the Australian Bureau of Statistics, as a means of raising overall economic growth on a sustainable basis.

This requires maintaining sound macroeconomic fundamentals, such as low inflation while actively pursuing further microeconomic reform measures.Ê The pace of reform could for instance be governed by an explicit or implicit rule, analogous to the way monetary policy is conducted, such that multi-factor productivity growth should not be permitted to fall below a minimum of, say, two per cent on average over the business cycle.

- BOX 1 -

Saving, Productivity and Growth

It is possible to analyse the respective roles of saving, capital accumulation and productivity as sources of growth with reference to a standard macroeconomic production specification of the form y=M.f(k) where y is output per worker or labour productivity, M represents multi-factor productivity or MFP, the most general measure of productivity, and k is units of capital per worker.

Figure 1 shows that aggregate output per worker (y) rises as capital per worker (k) increases, but at a decreasing rate since returns to capital diminish. One way of raising output per worker is to increase domestic saving as a means of accumulating more capital. Other things equal, a higher saving rate per worker (s) raises investment, the capital-labour ratio and increases output per worker from y0 to y1.

Box 1: Saving, Productivity and Growth

Saving, Labour Productivity and Multifactor Productivity

Alternatively, the diagram above shows that, instead of raising domestic saving, it is possible to achieve greater output per worker with the same capital-labour ratio by enhancing multi-factor productivity. Improvements in technology and policy measures that intensify market competition and the efficiency of resource use raise multi-factor productivity growth. These fundamental causes of productivity growth shift the production function upwards, generating more output for unchanged capital and labour inputs. The diagram also suggests that higher domestic saving rate and improved productivity can act in a complementary way to raise an economyÕs growth rate and living standards over the longer term.

References

Australian Department of Employment, Education and Training, Annual Report 1997-98, Australian Government, Canberra.

Fitzgerald, V. 1993, National Saving: A Report to the Treasurer, AGPS, Canberra.

Horioka, C.Y. and W. Watanabe 1997, ÔWhy Do People Save?: A Micro-analysis of Motives for Household Saving in Japan,Õ Economic Journal, 107 (May): 537-553.

Parham, D. and A. Makin 1999, ÔAustraliaÕs Productivity Performance,Õ Paper presented at the Pacific Economic Outlook Conference on Productivity, Pacific Economic Co-operation Council, Osaka, September.

Summers, L. and C. Carroll 1987, ÔWhy is U.S. National Saving So Low?Õ Brookings Papers on Economic Activity 2: 607-635.

Author

Tony Makin is Associate Professor of Economics at the University of Queensland.

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