Australia’s future in the unmeasurable economy

Is Australia up to the reform agenda laid out for it by the Harper competition policy review and the Productivity Commission?

If not, we may find ourselves slipping back permanently into the pack of mediocre economic performers, labouring to meet the demands of demographic change, with the social safety net and other key government services under pressure.  

Australia emerged from the decades of reform-driven growth and China’s boom as one of the world's richest economies but the combined productivity growth of our capital and labour has slowed. A less-comfortable future is lapping at our feet.

" The new economic reform will involve industries where economists are struggling to reliably measure output, let alone productivity."

In the first of its new five-yearly reviews for the federal government, the Productivity Commission warns labour productivity is now lower than in both the ‘golden era’ of the mid-1990s and the lengthy prosperous period from 1950 to 1970.

Unfortunately, no government has yet found the right moment to tell voters of the challenge at hand.

“If we were waiting for a crisis to indicate that government should act, there is none — just an inexorable slowing towards reduced opportunity, greater dispute over shares of a smaller than expected pie, and selective protection,” the commission says in a discussion paper written as part of the review.


The commission describes its recommendations as “a short list of thematic directions”, as opposed to the long lists of “must do” advice gathering dust on Canberra’s finely crafted bookshelves.

These thematic directions, which include reforms in healthcare, education and other key government human services, are said offer the greatest scope for deliverable medium-term productivity gains.

However, they also leave no doubt about the size of the task facing a reforming government. We are talking about the some of the most politically sensitive service industries in the economy, as well as the most politically powerful professions and the most formidable technical difficulties.

The economic reform we remember from the 1980s and 90s was mainly about tearing down barriers to competition and innovation in fairly standard product and factor markets and counting the benefits of the increased output and lower prices which followed.

It took enormous political courage and energy but it was technically relatively straightforward.

The new economic reform will involve industries where economists are struggling to reliably measure output, let alone productivity – what an American economist, Zvi Griliches, called the “unmeasurable economy”.

Even if we find a way to reliably measure the unmeasurable economy, and overcome the opposition of the powerful professions which inhabit it, just increasing productivity will not be enough.

Raising living standards will need something which came automatically with the reforms of the 1980s and 1990s but will not fall so neatly into our laps this time. That something is called “allocative efficiency”.

Productivity measures output per unit of input. Allocative efficiency is about using those inputs to produce what the consumers most want.

Productivity can be raised by increasing efficiency, which can take us as far as the current technological frontier, or by innovation which pushes the frontier outwards.

Neither of these supply-side advances will tell us what additional goods and services we should produce with our enhanced productivity. For that we normally rely on markets and the interaction of informed consumers and competing suppliers.

Simpler times

In his 1994 presidential address to the American Economic Association, Griliches explained the problem of measuring economic output and productivity in many of the service industries which now dominate employment in the advanced economies.

The national accounts, he said, were invented in simpler times, when economies were mainly agriculture and manufacturing.

“Imagine a “degrees of measurability” scale, with wheat production at one end and lawyer services at the other,” he said.

What makes the output, and therefore the productivity, of lawyers so difficult to measure is the value of their contribution to gross domestic product largely depends on the quality of their work.

The same is true for many other professional services where the output varies with the knowledge and creativity of the service provider.

Of course, where there are efficient markets for professional services, prices can provide a good guide to what consumers want and the real cost of producing it.

However, for two of Australia’s most important service industries - healthcare and the education of domestic students - there are no comprehensive sets of genuinely market-determined prices to signal what services should be produced.

These two industries are largely outside the “market sector” of the economy, as are other government-produced human services identified by the Harper committee as important candidates for reform, including disability care, aged care, public housing and correctional services.

The non-market sector accounts for about 20 per cent of Australia’s economic output.

In a report on service sector productivity published by the Committee for Economic Development of Australia (CEDA), health economists Jane Hall and Kees van Gool of the University of Technology, Sydney and Australian Unity CEO, Rohan Mead, appealed for the healthcare reform debate to take account of the need for allocative efficiency.

As professors Hall and van Gool put it, allocative efficiency means “outputs produced provide the highest social value. In terms of the health sector then, the highest value care is that which contributes the most to better health and the best investment gives the highest return in health outcomes for the resources committed.”

Increased efficiency

Innovations such as case-mix funding have increased the efficiency of public hospitals but the evidence of the wide variations in the rates of hysterectomies across Australia confirms the healthcare sector needs more than just improvements in productivity.

As a private health insurer, Mead advocated giving patients more market power over resource allocation. The healthcare system, he complained, “too easily accepts the historical primacy of producer interests over those of the patient. And it downplays palpable waste and inefficiency in the health sector diverting crucial resources away from those needing care”.

Of course, the asymmetry of technical knowledge and bargaining power between doctors and patients has been seen as a barrier to leaving healthcare to the market.

But, with the reform of health insurance, it is possible organisations like Mead’s could reduce the asymmetry by, for example, offering to purchase healthcare services on behalf of their members.

A more-competitive and innovative private health insurance sector was central to the Medicare reforms recommended by the Bennett review to the Rudd government in 2009.

In the present political environment, in which even the proposed use of the private sector to process Medicare bank transfers can be portrayed as a fundamental attack on Medicare, the scope for healthcare reform would seem to be very limited.

In truth, that campaign was just the most recent manifestation of a longstanding problem. The Productivity Commission has been urging governments to commission a full review of healthcare since the late 1990s, but no government has been prepared to confront the either the public’s unrealistic expectations or the sector’s powerful vested interests.

The need for further reform of the unmeasurable economy is becoming urgent. Services (excluding construction and the utilities) now account for around 60 per cent of gross domestic product and almost 80 per cent of employment.

As in other advanced economies, the dependence on the service industries is growing as traditional manufacturing migrates to the emerging market economies of Asia, Latin America and Eastern Europe.

High-end professional services, where measurement problems and anti-competitive regulation are greatest, will play a central role in Australia’s future trade with Asia’s burgeoning middle class.

Alan Mitchell is a former economics editor of The Australian Financial Review

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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