Start a debate about the economy - if we don't Australia will be left behind

Sustainability

The combination of climate change, the growth in the world's population, increasing urbanisation and the likely growth in average living standards will place serious pressure on a wide range of global resources, including food, water and energy. While it's not clear that climate change per se will be the unifying theme for a policy response, the issue will keep coming back in the context of resource management and environmental contamination.

As international management consultancy McKinsey has noted, almost 60 per cent of the world's GDP emerges from 600 cities, with half of global GDP sourced from 380 cities in the developed world. By 2025 one-third of the current 380 developed world cities will disappear from the ranking, having been overtaken by cities from the developing world.

The rapid growth in mid-sized cities, combined with the emergence of mega-urban environments, will bring new challenges for the supply of safe, high-quality food and water, and for the reliable supply of energy.

The result will be a renewed focus on energy, resource and environmental efficiency – and these may emerge as key drivers of productivity. If so, countries and firms at the forefront of these areas could gain considerable comparative advantage. This capacity for technological leap-frogging, combined with the need to address global and geographically specific environmental problems (i.e. climate change and air and water pollution), lies behind China's huge investments in low-emissions technologies. The US is also investing massively in these technologies. Australia is not.

Climate change is a real threat to Australia. Not just via its direct effects – that is, on rainfall patterns and agricultural production, or on the magnitude and frequency of severe weather events – but also because the way other countries respond could have serious implications for our competitiveness and capacity to sustain traditional export sources.

One key area of risk is the outlook for thermal coal.

In many emerging countries, concerns remain about inadequate access to energy. Some see this as promising a bright future for coal – after all, the technology to generate electricity from coal is relatively simple and commercially viable coal deposits are widely distributed globally.

However, over the next decade or so, the desire of some to revoke the social licence to produce and use thermal coal will likely become more influential – in part because the cost of alternative energy sources, and especially distributed-generation technologies (in contrast to centralised power plants), and advances in storage technology will become increasingly competitive.

Ironically, the pressure to revoke or curtail the social licence is likely to be strongest in advanced economies such as Australia. But, in a scenario where the world had adopted a global carbon price, Australian coal exports would likely displace higher-emissions-intensive coal from other countries during the transition to sustainable low-emissions technologies. The absence of a global carbon price, combined with pressure in advanced economies to revoke coal's social licence, is likely to result in a classic case of leakage of coal production to higher-emitting sources offshore, with negative global consequences.

And this could occur at a time when the sector is suffering from two other forms of disruption: the massive increase in global supply that has outstripped growth in demand, meaning a structural or long-term decline in price; and the competitive threat to coal from gas and unconventional energy sources in the United States.

Informed Chinese commentators have also indicated they believe China's thermal coal demand is at or close to its peak (demand actually fell in 2014) and that steel demand will peak in this decade.

The issue of the social licence and resource efficiency is also playing out in other countries – in Canada, Ontario is joining the California-based Western Climate Initiative emissions trading scheme, which already includes British Columbia and Quebec. Alberta, the home of the oil sands, has committed to doubling its carbon tax to $C30 by 2017, and may rescind proposals for two major oil pipelines, while BC is in the midst of debate over the export of LNG.

Both Canada and Australia, like many other countries, are likely to end up with a suboptimal patchwork quilt of initiatives, whereas a coherent, national response could deliver more effective emissions reductions at lower cost.

Responding to climate change – through both mitigation and adaptation – requires countries to prepare for long-term transitions that will have a disproportionate impact on some industries and regions. As such, a key focus should be on finding ways to maximise the positive opportunities for employment and growth from the enforced transition. Thought about this way, a successful policy regime to respond to climate change has similarities to Australia's approach to structural reforms that Australia pursued during the 1980s and 1990s.

More generally, climate change poses risks to which financial market regulators and company boards have, to date, given little attention. They have been slow to acknowledge the risks to the financial sector – banking, insurance, superannuation, capital markets and infrastructure – of the direct financial exposure to carbon-intensive assets that may be priced, regulated or stranded by technology or which may incur increased legal risk through their operation. And little attention has been paid to the knock-on effects to macro-economic stability of falling demand for carbon-intensive exports – a particular issue for Australia and other fossil-fuel dependent economies.

Admittedly this situation is changing, with the G20 recently asking the Financial Stability Board to "review how the financial sector can take account of climate-related risks". The Bank of England has also begun considering the ramifications of climate change in its regular deliberations on risks to financial stability and is assessing climate risk for the insurance sector.

Technology

The impacts of the digital revolution and the explosion in new avenues of competition are clear for all to see, whether for consumer- or business-facing firms, for sectors such as the media, or institutions like government.

These changes are remaking traditional market boundaries and eroding the long-held distinction between the traded and non-traded sectors of the economy.

Two key issues emerge from a consideration of current rates and types of technological change.

First, is the rate of global technological innovation slowing or accelerating? The answer to this has implications for productivity growth, the labour share of income and inequality within and between countries.

If it is accepted that much of the future technological change likely to affect today's industries will be labour-displacing, this raises the question of how countries should prepare to manage that transition. Since it's difficult to be specific about which types of labour could be displaced, and when, this suggests a priority should be placed on measures that boost technology-related skills and encourage agility among firms and workers.

Second, it has become common to discuss the role of technology as a market-disrupter. However, technological change has always been a disrupter. As such, it is important to be clear about why the current wave of change is different to what has gone before (is it simply a matter of scale, or is it inherently different?) and ask again how best should workers, firms and governments prepare for this.

Those who believe the pace of technological change is slowing point to slower global productivity growth in recent decades, while those arguing for acceleration point to breakthroughs in fields as diverse as IT, bio-tech and materials technology.

It is clear that national statistical agencies are lagging in their ability to measure the productivity and economic gains from the emergence of new products and processes enabled by the digital revolution. That said, it is hard to believe that mismeasurement alone explains the magnitude of the dramatic slowing in multi-factor productivity growth over the past decade. This has led some to argue that innovation overall is slowing, notwithstanding rapid progress in some high-profile areas. And even some areas where innovation has been rapid may not be seeing a commensurate increase in productivity.

Technology as disrupter

As noted, technological innovation has often acted as a disrupter of the status quo.

This prompts the question: is disruptive innovation more prevalent today or is the term now simply being applied to ordinary improvement in products and processes – what has sometimes been called "sustaining innovation"?

It is clear the speed of the dissemination of new products and processes has accelerated in recent decades, but this is, of itself, not proof of a greater prevalence of disruption.

Yet many existing industries clearly face technology-driven disruption. As is known from the celebrated case of Eastman Kodak, failure to anticipate and/or respond to such shocks can lead to the overthrow of the existing order and even to the virtual disappearance of former industry and technology leaders. And Kodak is far from alone.

As Charles Darwin said: "It is not the strongest of the species that survives, nor the most intelligent. It is the one most adaptable to change."

While Australia has been a relatively poor product innovator, anecdotal evidence suggests a better record as a process innovator. Importantly, at least in the case of sustaining innovations, it is not necessarily where the product or process is invented – rather, much of the benefits appear to accrue to early adopters, and on this metric Australia has a stronger track-record.

The focal point for true disruption will be the firm and its response to emergent technologies and business models – success seems likely to be determined by the willingness and capacity of firms and workers to take risk and innovate. As such, business, not government, will be the determinant of Australia's future economic success.

The ability to cause, and respond to, disruption will be influenced by the human capital Australia is able to deploy into this new environment. This suggests a renewed focus on the teaching of science, technology, engineering and mathematics (STEM) should be a policy priority. But this seems likely to be a necessary, but not sufficient, condition for success if, as argued by American economist Edmund Phelps, "young people are not taught to see the economy as a place where participants may imagine new things, where entrepreneurs may want to build them and investors may venture to back some of them".

As such, a key focus of government policy should be on how best to create an innovative, entrepreneurial business culture. It also means considering ways in which to foster the willingness and capacity of firms and government to utilise the massive, and growing, holdings of data now available.

By its nature, true disruption is hard to forecast. If it is not possible to predict what disruption will have an impact on a market or firm, or when, what form of business model is most likely to handle these shocks the best? Drawing on the work of American scholar, statistician and former hedge fund manager Nassim Nicholas Taleb, it seems plausible that entities that are inherently centrally organised – with rigid structures and modes of operation, and limited openness to new ideas – are less likely to be able to adapt quickly, as such centralisation magnifies the impact of deviations from the norm.

If true, this probably applies as much to governments as it does to firms, and may explain the apparent limited capacity of governments to respond substantively to the forces reshaping the world economy and individual societies.

A key message from these developments is that governments everywhere need to devote time and resources to tackling these issues, domestically and multilaterally.

Demography

Demographic change is not a uniquely Australian challenge. The UN has pointed out that, in less than a decade, globally the over-65s will outnumber the under-5s for the first time ever. While each country's experience will differ, it is fair to say that on average this will reduce workforce participation and therefore lower potential growth in GDP and living standards. In Australia's case, it is also likely to result in higher demand for government services.

One of the consequences of population ageing is that the ratio of workers to older people decreases, in some countries quite markedly. Australia's latest Intergenerational Report (IGR) indicates the number of Australian workers for every person over 65 has fallen from 7.3 in the 1970s to 4.7 now, and is heading towards 2.7 by 2055.

Reflecting this, by 2055, Australia is likely to have about 40,000 people over 100 years of age, and 2 million over 85, out of a population of almost 40 million.

The ageing of the population will make it even harder to deliver the sorts of growth in living standards that Australians have become used to, without dramatic improvements in productivity.

Yet population ageing means the age of the median voter is also rising, which may make it increasingly harder to achieve reform.

Shifting economic weight

Emerging markets and developing economies have grown to make up slightly more than 50 per cent of global GDP (on a purchase-power parity basis) and, on reasonable assumptions, are expected to increase their share towards 60 per cent of world GDP within the next 10 years, with much of that growth potential centred in the Asian region.

This is not to suggest the growth paths of EMEs will be smooth – far from it.

Indeed, the recent experience of China illustrates the challenges faced when attempting to manage a transformation towards greater reliance on market-based instruments – speculative bubbles, excessive risk-taking by firms and households exacerbated by poor or non-existent risk assessment by financial institutions, and knee-jerk policy reactions to the dislocations that arise during the adjustment process.

Put another way, EMEs by their nature are at heightened risk of policy missteps, meaning their trade and investment partners have a heightened need for good policy of their own to help deal with any flow-on effects – the more so the deeper the economic relationship. As such, Australia's deep engagement with China should be increasing the incentive for policy reform in Australia.

The challenge is not, however, the short-run fluctuations in emerging-market economy growth.

Rather, it is that on current indications, and notwithstanding bouts of instability, EMEs are heading to be an increasingly important part of the world economy. This increase in weight needs to be recognised in the governance structures of global institutions and in the attitude of existing powers to new institutions proposed by EMEs.

Potential growth

A common thread among these four factors is they all have big implications for global and national growth potential. Individual countries will be differentially affected by these changes, but each is vulnerable in some way to how one or more of these forces play out.

The right sorts of policies would minimise the negative effects of climate change and population ageing, while grasping the opportunities offered by rapid technological change and shifting economic weight. In Australia's case, we are vulnerable to negative developments from all four and have been slow to pursue the countervailing opportunities.

This is despite mounting evidence suggesting potential growth has already slowed in recent years, although the reasons for this remain unclear.

If Australia's potential growth has slowed from the commonly accepted estimate of 3 per cent per annum to, say, something closer to 2.5 per cent per annum, this means the economy will be about 5 per cent smaller than otherwise over the course of a decade – somewhat akin to the loss of GDP from a recession.

Slower potential growth also means that assumptions about the magnitude of the existing output gap – the cumulative gap between what the economy is capable of producing and what it is actually producing – are called into question.

Since the closing of the output gap underpins the Australian government's assumptions of a return to budget surplus, a smaller output gap means the ability to deliver the proposed fiscal consolidation is also at risk, while suggesting the structural budget deficit is even larger than currently estimated.

More importantly, if the economy is unable to sustain growth much faster than 2.5 per cent, in the absence of serious structural reform, it implies that "normal" rates of unemployment have risen beyond the widespread assumption that the non-accelerating inflation rate of unemployment is about 5 per cent.

If slower potential growth is a result of weaker innovation and productivity, it will also be reflected in slower growth in living standards, which is already expected to be less than half of that experienced over the past two decades. In contrast, if the slowing in potential growth solely reflects slower growth in population, the outlook for living standards would be little affected.

Insularity

As has been increasingly apparent, the 20th-century world is being recast. The combination of ageing populations and sustainability challenges, the emergence of new technologies and the shift in economic weight towards Asia and away from the advanced economies of the trans-Atlantic, is leading to pressure on global institutions and modes of governance. It is recasting areas of strategic interest and competition, bringing forward both national and global policy challenges for countries to navigate while opening up massive opportunities for those with the foresight to position their nations to take advantage of this era.

A forward-looking, confident, flexible and innovative Australia has much to gain from these developments, notwithstanding the challenges.

The complacency engendered by past economic performance – itself a function of hard work and reform of the 1980s and 1990s, assisted by serendipity in the form of demand for Australia's resources over the past decade – has seen the emergence of an insularity in Australia.

Indeed, New Zealand Prime Minister John Key has been reported as describing Australia as suffering from a lack of confidence, a recession "temperament".

Australia is not unique in its current bout of self-absorption. Many countries more deeply affected by the GFC are also suffering from a loss of confidence and questioning their prospects.

But if Australia, a country long admired for its forward-looking national policy debates and willingness to embrace change, favours the status quo over reform, and acts as if the reshaping of the world will leave it untouched, it will be continuing the complacency of the past decade and be unprepared for what awaits.

Our political discourse is failing to provide the public with an explanation of global or national economic developments, or a road map for the future.

This vacuum of leadership, and the tendency to talk rather than act, is facilitating the emergence of a wide array of voices on policy directions. But rather than being a healthy sign of a national discourse, the diffusion and fragmentation of debate is allowing groups to conflate their own personal interests with the national interest. True leadership from the political class is required to move the debate to the workable centre from where reform in Australia has always been driven.

Australia's current bout of complacency will be broken and reform will restart – the choice confronting Australians is whether they are willing embrace change or have it forced upon them.

This is an edited extract from The Lucky Country – Has It Run Out of Luck?, a forthcoming working paper from the Griswold Centre for Economic Policy Studies, Princeton University. It was also one of several that formed the basis for debate at the recent National Reform Summit, sponsored by The Australian Financial Review, The Australian and KMPG.

Martin Parkinson was secretary of the Treasury between 2011 and 2014, and is currently Visiting Fellow at Princeton University.