Prosperity is the Best Protection

This article from the Winter 2020 edition of the IPA Review is written by UNSW Professor Emeritus of Economics, Wolfgang Kasper.

The unprecedented Corona slump of 2020 confronts Australians with massive challenges. Reviving the battered economy has been made more difficult by confrontational acts of Communist China aimed at limiting Australia’s sovereignty. This demonstrates the vulnerability of free economies, which thrive thanks to open trade and capital flows. Little wonder one now hears growing calls for safeguarding national sovereignty by economic protectionism and a retreat from globalisation, but such moves would hamstring the post-Corona recovery.

ON GOOD GOVERNMENT

Before addressing the conflict between prosperity and national security, two general points have to be made.

A primary function of government is to protect citizens from external and internal enemies, and major calamities. When medical officials spooked the public and most leaders about the Corona threat, massive and costly curtailments of individual freedom were widely accepted.

By now, the dangers are better known and to a considerable extent have been overcome. Elected leaders therefore should again weigh the trade-offs between all universal values that underpin good government: liberty, security, justice, equity, peace, prosperity and the conservation of a liveable environment. The ‘uber collective’ of Australia’s National Cabinet—justified in the perceived emergency—showed governments are good at prohibiting and spending, but poor at creating real wealth. Now, it is time to end rule by decree. We, the people, demand our Constitutional liberties back!

One major reason for this is that people, who operate freely, will search for and test useful knowledge, helping everyone to overcome the costs of the COVID-19 calamity, restore employment and repay those massive public and private debts. The insight that economic freedom is good for prosperity—reconfirmed elsewhere, time and again—must guide policy to recover from the Corona slump.

The primary concern is to improve the productivity of Australian workers, who earn high wages. High and rising wages have to be matched by high and rising productivity, for it is the wage relative to labour productivity—labour-unit cost—that matters to whether a job is sustainable in our wide-open economy.

Battalions of regulatory bureaucrats have to be redeployed or sacked.

In some countries workers earn even higher incomes than here, yet jobs are safe because government administrations and labour organisations support the international competitiveness of the nation’s jobs.

THE NECESSARY RE-ORIENTATION

Healthy job creation thus requires a focus on the comprehensive mobilisation and flexible employment of all productive assets—labour, skills, capital goods, technology and natural resources. When this is the overarching policy focus, competing enterprises incur the necessary technical and commercial risks. But when confronted with manifold, changeable and costly regulatory obstacles, they won’t. Businesses (and young people who prepare for careers) require stable and streamlined laws and regulations which enhance the framework for discovery and competition. Job creators thrive even more when assisted by a workforce that deems itself a partner in the joint venture of growing the productive potential. In our dynamic world, the opportunities to discover new sources of wealth creation never peter out.

This is the gist of supply-side economics, which contrasts with the naïve belief that growth and job creation can be sustainably influenced after a shock like the COVID-19 episode by demand-side policies that manipulate the aggregate spending plans of consumers, borrowers/investors, foreigners and governments by monetary and fiscal means.

Therefore, the recommendation for recovery policy is to concentrate on a gutsy, comprehensive reform effort. Since the start of the 21st century, red and green tape has been allowed to proliferate, resulting in deplorable labour productivity and third-factor growth, i.e. the use of new knowledge.

The costs and benefits of all health and safety measures will need to be re-examined critically. Often contradictory environmental and energy regulations need to be scrutinised as to their impacts on productivity and innovation. Regulatory barriers to the better use of land and water are also called for. Australia’s great competitive advantage of cheap, abundant energy resources must be exploited to the fullest by doing away with contradictory and counter-productive bans and subsidies.

Building projects and new business ventures often face unnecessary administrative delays, and the costs of multiple permits to create new jobs are often insuperable. For this to happen, State and local governments need to embrace a market-friendly mentality, expediting and litigation-proofing approvals. The axe needs to be taken to the countless obstructions erected by local administrations that too often hamper small businesses. Battalions of regulatory bureaucrats have to be either redeployed to constructive ends or sacked.

It is dubious whether roundtables between Big Government, Big Business and Big Unions can achieve the required re-orientation of government administrators and the leaders of organised labour. In the present emergency, more roundtables may waste precious time and will probably disregard the needs of small and as-yet unborn enterprises.

Rethinking the fundamental approach to policy may well be supported by the electorate after the massive and unforeseen drop in national income, pervasive job destruction, huge asset losses and debt burdens. The sobering effects will be far-reaching and likely to promote economic realism. The COVID-19 pains doubtlessly will cure many of the naive belief that the national economy is a magic pudding which can be painlessly re-engineered to fulfil the dreams of Get-Up, St Greta and Ross Garnaut. Green and anti-capitalist ideologues, who admonish us to make do with less, are bound to discover—to adapt an African saying—that “it is easier to separate people from their shadows than from their aspirations for better material comforts”.

Deregulation enabled us to achieve sustained economic growth.

To gain a clearer perspective of what challenges lie ahead over the next decade, we should look back to similar calamities. To my mind, the closest historic precedent to the current crisis is the decade of the 1930s. After a period of cheerful growth, the 1929 stock market crash caused a recession. In the US, policy makers reacted with the Taft-Hartley Act (1931) which tried to make America great again through protectionism. The Commonwealth adopted trade-impeding preference schemes favouring products from Empire while National-Socialist Germany went for autarky (self-sufficiency in all products). World trade contracted by 90 per cent, amounting to a massive destruction of productivity and jobs. This—and the spread of anti-business interventionism made possible by the new protectionism—turned the recession of 1929 into the long-lasting Great Depression of the 1930s. Post-2020, no one will want to re-run the 1930s, let alone the disastrous decade that followed.

If we want to avert such a future, we can learn much from the experiences of the 1980s and 1990s. In the first phase of reform, the Hawke-Keating ALP Governments treated our heavily administered labour markets and big government as sacred cows, so that the benefits petered out. Labor’s corporatist ‘Accord’ produced the famous ‘productivity underhang’. The subsequent Howard-Costello regime achieved partial reforms of industrial relations and government programs. Despite the political limitations, deregulation—including the opening of the economy to trade and capital flows—enabled us to achieve sustained economic growth, inspired a can-do spirit, overcame the notorious cultural cringe and earned us a strong and respected international position. These were important gains, which of course came with the inevitable pains of structural adjustment.

Some of the reforms were frustrated by unrealistic demands that “no one must be worse off”, which created undue rigidities and locked valuable resources into outdated, unproductive uses. Redistributional battles—the hereditary malady of Australian politics—would thwart any promise of real recovery in 2020-25.

After the government-mandated disruptions, flexible restructuring and productivity improvements will depend crucially on well-functioning capital markets where savers meet borrowers, planning to invest in capital goods. The price—the interest rate—should move freely to elicit savings and ration the demand by investors. In a living, dynamic economy, capitalists unable to earn enough to pay the interest—because they refuse to take risks, incur unsustainable debts or misread market signals—should face losses and even bankruptcy. Bankruptcies allow capital, such as equipment or buildings, to change hands, which makes it easier for new owners and managers with better ideas and new entrepreneurial energy to begin production. Well-functioning capital markets thus come with a ‘capitalist cleansing mechanism’. Alas, bankruptcies by well-connected individuals and firms seem nowadays almost verboten, as most Western capital markets are distorted by expansionist central bankers, who adhere to the Keynesian illusion they can ‘print jobs’, and treasury departments, who are under the illusion their deficits can be financed painlessly without drawing on genuine savings.

Productivity growth requires upholding the enduring merits of economic openness.

Dysfunctional financial systems allow ‘zombie firms’ to persist, despite contributing little to productivity. If the nation’s insufficiently responsive supply apparatus is then met by artificial demand stimulation, the price level will rise. This in turn will not only make it harder for potential producers to plan ahead, but hurt savers and retirees on fixed incomes.

PROSPERITY AND SECURITY

If there are lessons of history, one must conclude that necessary domestic reforms will not happen in a more closed economy. It is no coincidence 1930s protectionism enabled the Roosevelt and Hitler governments to resort to massive domestic interventionism, which hampered job creation. Levels of high employment were only reached after national industries were mobilised for war. Nor is it a coincidence that Australia’s reforms of domestic markets post-1980 were flanked by tariff cuts, the floating of the exchange rate and the opening of markets to inward and outward capital flows.

Protectionist policies did not produce a great car industry.

Unfortunately, the political arm-twisting of free nations by a probably insecure Chinese Communist leadership now triggers understandable calls for a new protectionism and a retreat from globalisation. Demands for governments to somehow engineer new local manufacturing capacities ignore the fundamental fact that organic growth processes invariably go along with structural change. For example, the relative size of a growing child’s head shrinks relative to the limbs. Likewise, size ratios in the real economy change in systematic ways as incomes rise. Thus, it was natural for the share of industrial output in GDP to decline once Australia had reached 1960s income levels. With manufacturing no longer being the growth engine, services took over. When the Whitlam and Fraser governments tried to stem the underlying economic forces, propping up manufacturing by tariffs and subsidies, this became costly and ultimately futile. Forced re-industrialisation in response to the China threat would have similar stifling consequences.

Speaking personally, I may be hyper-sensitive to the threat of neo-protectionism because I was deeply involved with the tariff and foreign-investment debates of the 1970s to 1990s. I also grappled with difficult arguments about the perils of economic openness for national security. Respectable military analysts and not-so-respectable industry lobbyists argued about the consequences of a shrinking manufacturing base and growing trade dependence for defence support and logistics.

There was also strong but wrong-headed and self-interested lobbying to protect inefficient, technically inept defence industries. Most uniformed analysts, however, wanted ‘more bang for the Defence buck’ by buying overseas and pointed to often poor support from mollycoddled local defence suppliers. Twenty-five years ago we concluded there were no facile solutions to the new vulnerability, but also that we ought not prepare for the last war or a long blockade.

As of 2020, the situation has changed. Our economy is intimately interwoven with that of an increasingly unfriendly PRC. Decoupling looks tempting, but that would be near-impossible and very costly. As should be clear from what is said above, productivity growth requires above all upholding the enduring merits of economic openness. Therefore, a more judicious, selective approach is needed.

Where security concerns are real, the costs and benefits of any possible reaction to the China threat need to be analysed case by case and in careful, critical ways. We must guard against self-interested lobbies that hope to profit from new trade and investment obstacles, which would run counter to the highest priority in economic policy post-COVID-19, namely the fostering of productivity. Security analysts must also take into account that neo-protectionism and security-focussed interventionism would weaken the long-term growth potential, and with that inevitably the long-term capability to defend our sovereignty.

Before listing a few tentative and admittedly second-best ideas on how to cope with a possible confrontation by China, it must be said that granting China equal trade and investment status in the World Trade Organisation in 2001—and that with undeserved less-developed-country concessions—was wishful thinking. Western leaders knew all economic activity in China is subject to the primacy of the Communist Party. By now, WTO rules prevent us drawing an economic iron curtain around China. Yet, Beijing feels less obligated to stick to the letter and spirit of the WTO. Defence hardliners also overlook that international trade is conducted between businesses, not governments.

We are told that from now on Australians will simply have to pay more for imports to safeguard national security. By what administrative device is this to be accomplished? Defence experts and closet neo-autarkists fail to spell out the methods they have in mind. New tariffs on strategic products? Import bans or import bans on products made in China? Or more likely, industry subsidies to preferred producers of the sort once on offer for car assembly and now submarine construction? After the COVID shock, governments simply cannot finance such costly subsidy schemes.

Autarky was a doctrine for the 19th century when people exchanged cloth for wine.

Targeted import protection is undoubtedly justified in a very few core areas, such as the ban on Huawei technology for 5G. But that argument cannot be extended very far without ruining the economy, violating numerous international trade agreements and risking retaliation.

Can we enhance national security by maintaining onshore stocks of essential materials at taxpayers’ expense? This argument may be valid for a strategic oil reserve. Petroleum is central to virtually all transport and can be stored. However, any affordable reserve of fuel will only postpone disruptions by weeks.

Some now also demand national stocks of pharmaceuticals, although most can be imported from the US, India, Germany and Switzerland. Do strategic thinkers realise just what unimaginable variety of pharmaceuticals we import, and how short the shelf-life of some medicines is? Most laymen find it hard to imagine the diversity of inputs into present-day consumption and production. Even local supermarkets carry thousands of different items. A Dreamliner or a jet fighter require tens of thousands of components to fly safely. Autarky was a doctrine for the 19th century when people exchanged cloth for wine. Now, there are few substitutes for most of the highly specialised bits and pieces essential to keep machines, cars, household goods and public services going. We have to accept we depend irreversibly on countless imported inputs for keeping our complex economic apparatus going. And many come from China.

Many argue for diverting trade and capital sourcing away from China, but whereto? More US or Europe connections? Fine, if costs and product qualities permit. But many manufacturers from China are overwhelmingly cost-competitive, so trade diversion by government diktat would inflict enormous cost. Diversification to India? That is a joke for people familiar with India’s production capacities, quality standards, and tendency to switch off exports to advance domestic political ends.

Australia has some leverage as an exporter to China, despite the import/export asymmetry.

Australia has become the world’s leading exporter of liquefied natural gas. Photo: 青空白帆, Wikipedia Creative Commons

It will take a major, persistent effort to build a free-world economic alliance of mutual support against China’s threats, now the US seems to have vacated chairmanship of the free world. Having long opposed foreign-investment controls, I am now convinced we must differentiate between proposals by investors from socialist dictatorships and proposals from private investors in free-market democracies. I see no need to worry about national sovereignty when investment proposals come from countries where the rule of law prevails. Nor need Australian businesses worry about placing their capital in economies where they can appeal to independent courts if suffering political discrimination.

From now on, the government should therefore make investment approvals conditional on reciprocity. If Australians enjoy the same treatment as national investors in a country, investors from that country remain welcome here, too! If not, then our authorities must be free to intervene. Particular caution must prevail when PRC investors buy into businesses that own leading-edge research and production capabilities. European firms acquired by Chinese interests, who received guarantees that there would be no production and job cuts, soon found their research departments relocated to China and their innovation potential drained.

Australia has some leverage as an exporter to China, despite an asymmetry between import dependency and export leverage. Some Chinese buyers depend on specific supplies from Australia. Let’s, for example, think what would happen if the export of a specific grade of coal were stopped. Modern power plants are finely tuned, and all coal is not equal.

We also have leverage in certain food categories. Solar panels imported from China come with substantial consumer subsidies; can that be stopped to send a signal? It is worthwhile to identify cases where Australian authorities might respond to unacceptable political arm-twisting. Networking with other free nations will raise the effectiveness of unavoidable retaliation.

These arguments are uncomfortable for genuine liberals and hard to defend in public.

Many Australians have not foresworn the protectionist mentality of old and now use China fears to turn the clock back. If they succeed, the all-important bonfire of red and green tape will not happen.

A heedless pursuit of national security would bring economic stagnation and political instability.

Labour-unit costs will remain uncompetitive. We should therefore remain extremely cautious when tweaking our commitment to openness. If exemptions to the free-trade maxim were to get out of hand, a heedless pursuit of national security would bring economic stagnation and political instability. The post-Corona economy would then have the bounce-back capacity of a beanbag. We will then be both poorer and less secure.